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Past year paper in dec 2017 Q4 a)
Hi Sir, at answer Q4 a) area of Discussion, the last sentence mentioned if Wardegul co feels there is possibility the interest rates will be higher than 5.41%, the point at which 94.25 option would not exercised, it may choose this option rather than the future.
My quires are why they will choose this option when the 94.25 option would not be exercised, and the interest rates higher than 5.41% ?
Also if interest rates higher than 5.41%, will result in lower effective interest rate than 4.56% at 94.25 exercise price.
In addition, is 5.41% comes from 4.2% + 1.1% + 0.11% (basis)??
For the option not to be exercised, the futures price would have to go below 94.25.
The futures price will be 100 – interest rate – 0.34 (unexpired basis).
For this to be equal to 94.25, the interest rate has to be 5.41.
Thank you, Sir.
But why they still choose this option even it would not be exercised? Is that 5.41% highee than 4.58% of future?
The whole point of considering options is that although they limit the minimum interest rate they allow the company to get the benefit of higher interest rates. If interest rates go above 5.41% then they would not exercise the option and so would get the benefit of the higher rate, whereas futures fix the effective rate whatever happens to the interest rate.
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