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1)In the examiners answer to the Pilot paper q2
She has compared theoption exercise price to the futures price todecide whether or not to exercise the option,is it ok if i compare the option exercise price to the prevailing spot rate at the date when we start the loan(ie transaction date)?2)the examiner has chosen the lower put option(@ 96.00 so higher int rate) and chosen to sell the call at a higher value(@96.50 so lower interest rate) What is the reason behind that?
(pilot paper in BPP kit Mock exam 3)
Thanks alot
You will have to tell me which of the pilot papers you are referring to (there have been three in the last few years).
I keep telling you that I do not have the BPP books 🙂
I think its the one made for the dec 2012 exam
But still,can u advise me which int rate has to be compared with the interest rate option to know whether to exercis or not?Thank you 🙂
You do not compare it to the interest rate – you compare it with the value of the futures at the date on which deciding whether or not to exercise the option.
There are no traded options that are directly on interest rates.
The option is the right to buy or sell futures at a fixed price on a future date.
1)So if we exercis the option,we pay the relevant rate at which we bought the option(adjustedfor our credit risk)right?
2)if the qs says that the rate on the transaction date will be for eg 6% and we can exercise the option at 5%,so why dont we compare these 2 rates when deciding whether to exercise the option or not?
With traded options, you pay interest on the borrowing (or receive interest on a deposit) at whatever the interest rate happens to be at the start of the loan (or deposit).
Separately, you decide whether or not to exercise the option – the option is to buy or sell futures on the date the loan or deposit starts, at a fixed price. You will only do this if buying or selling the futures at a fixed price generates a profit.
You really should watch my lecture on this to see how they work.
You cannot simply compare the interest rate with the interest rate implied by the strike price.
I got it.Thanks alot Sir 🙂
But for part 1)which i asked above,can u give me a general rule that if we are the borrowers and are taking an interest rate collar position,which option prices do we choose for buying the put and which one for selling the call?
There is not a general rule – depending on how many exercise prices are available there will be several possibilities.
Best for collars is to read the article about them that I have posted here. The link to it is:
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