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Dear Mr. John,
Often in Option question, i justify the most favorable exercise price and measure hedging on that price only.
For call option: the highest value of (interest – premium rate) are chosen.
For put option: the lowest value of (interest + premium rate) are chosen.As a result, 94.25 is chosen for Phobos in this case. However, the examiner take 94.00 as it nearliest reflect current position (Libor of 6%)
The outcome of my choice is: effective interest rate is 6.51% (if Libor is 7%) and 5.8% (Libor 5%)
=> average is 6.155%While examiner’s: effective IR is 6.63% (Libor 7%) and 5.67% (Libor 5%)
=> average is 6.15%However, the maximum expected interest rate is 6.6%. From point of borrower, the IR is expected to raise and if option of 94.25 is choose, in any case, it much better hedge the risk.
Therefore, 94.25 should be chosen.
Mr. John, what is your point here?
Many thanks Sir in advance!
The examiners answer is very poor for several reasons (the examiner has been changed twice since this question).
Firstly, calculating an average effective rate for the options is rather meaningless – the end result will be one or the other, not an average.
Secondly, as you point out, the answer ignores the fact that the treasurer wants to keep the borrowing rate below 6.6% and it is only 94.25 that would achieve that.
Thirdly, the answer nowhere mentions that although 94.25 is the better option in terms of fulfilling the objective (of keeping below 6.6%) it is the more expensive choice if interest rates fall (because of the higher premium).
More recent questions have been more sensible. The marks are mainly for proving that you know how options work (if time, try all exercise prices, but just trying one will get the majority of the marks) and discussing the fact that different exercise prices will set different limits on the maximum interest but at the same time will incur different costs (which becomes relevant if the interest rates fall).
(Incidentally, your results for an exercise price of 94.25 are correct 🙂 )
i often calculate outcome of hedging for one exercise price only :D.
Thank you Mr. John for your useful sharing and advice 🙂
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