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Dear John,
Can you please explain how the examiner calculate cost of borrowing rate of 4.7% & 4.6 % and why they choose exercise price of 95.50 in Keshi Co . I am stuck with this %.
And please explain how to choose strike price from two or three strike prices (just like in this question) ?
Paragraph two of the question says that the current rate is 3.8 + 0.4 = 4.2%.
If interest rate increase by 0.5% (as again in paragraph 2) then it will go to 4.7%.The 4.6% is the fixed rate offered by Rozu on the swap (given in the third paragraph from the end of the question).
With regard to the strike prices, there is no ‘best’ strike price – different strikes fix different limits, but the better the limit the greater the premium (and the premium may be ‘wasted’ if the interest rates move in our favour and the option is not exercised).
Ideally you would show the calculations for all strike prices (as the examiner has done in this answer) – it doesn’t actually take too long once you have done it for one of them then it becomes quicker for the others. However, if you are short of time, then since most of the marks are for proving that you understand how options work, doing it for just one strike price (and then mentioning that others are available) will get you more than half the marks.
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