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Dear John,
It is not clear for me why in the Kaplan question Phobos CO, March options at a price of 94.00 are choosen. I think that 93.75 is not being considered as the treasurer wants to keep the maximum borrowing rate at or belo 6.6%. But why not to consider the strike price of 94.25?
Thanks in advance.
It is a qestion from December 08 exam.. It says Libor is currently 6%. Phobos can borrow at a fixed rate of LIBOR+50 basis. The treasurer would like to keep the maximum borrowing rate at or below 6.6%.
There are three strike prices for put options:
93.75
94.00
94.25
It says that options at 94.00 should be bought and makes no calculations for the other two.Why?
94.00 effectively limits LIBOR to 6%, so when adding the 50 basis points, this comes to 6.5%. This can potentially limit to below the required 6.6% (subject to the premium payable).
93.75 will limit to 6.75% (using the same logic) and ignoring the premium and so this cannot achieve the requirement.
However, 94.25 will limit to 6.25%, which subject to the premium could achieve the requirement.
Therefore I would consider both 94:00 and 94.25, although just looking at one of them would still get most of the marks.
(This is actually an awful question for other reasons – it was set by the previous examiner who set some dreadful questions but is fortunately no longer the examiner 🙂 )
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