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Good day tutor,
I can fully understand the workings behind the calculation of minimum return from a collar hedge in part b(i). What I do not understand is the calculation of maximum interest that could be received in part b(ii).
Extract from question:
Strike price
95250 Calls- 0445 Puts- 0.085
95500 Calls- 0.280 Puts- 0.17
95750 Calls- 0.165 Puts- 0.305LIBOR is currently 5% and the company can invest short-term at LIBOR minus 25 basis points.
Answer:
The maximum interest rate that is possible under the selected hedge is 4.75%, equivalent to the put option exercise price of 95250. Troder will not have exercised its option, but taken advantage of the rate being above 4.5%.Net return = 4.75 – 0.25 – 0.280 + 0.085 = 4.305%.
My question is…………..
Why cant we use the combination of 95250 (for put) and 95750 (call) instead?
This combination would give us a net return of:
4.75 – 0.25 – 0.165 + 0.085 = 4.42%, wouldn’t it?Thank you. 🙂
But the question asks for the maximum interest that could be received under the hedge selected in part (i) of the question.
The collar selected in part (i) is the only one that results in the minimum return required.
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