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John Moffat.
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humai
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Sir in this question, in examiner answer regarding recommended hedging strategy examiner has written following after FRA discussion
If Wardegul Co believes that the bank will default, the choice will be between the futures and the options.
Again the 95·25 option may be ruled out because it gives a much worse result if interest rates fall to 3·6%. The futures give a marginally better result than the 94·25 option in both scenarios but the difference is small. If Wardegul Co feels there is a possibility that interest rates will be higher than 5·41%, the point at which the 94·25 option would not be exercised, it may choose this option rather than the future.Sir instead of the above para, can I write the following, would it be correct?
If Wardegul Co believes that the bank will default, the choice will be between the futures and the option.
Hedging using futures fixes the rate at 4.58 %. If interest rate falls by 0.6% then hedging using futures gives the highest return. However, if interest rate increases by 1.1% then hedging using options gives the highest return. Thus, the recommended hedging strategy would be option with 95.25 exercise price
John Moffat
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No – although you would get some marks, it would not get you the full marks.
As the examiner has written in his answer, using the 95.25 option gives a much worse result if interest rates fall,
humai
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So if amend it a little and write following then would it be fine
Hedging using futures fixes the rate at 4.58 %. If interest rate falls by 0.6% then hedging using futures gives the highest return. However, if interest rate increases by 1.1% then hedging using options at exercise price of 95.25 gives the highest return, however, it also gives the worst return if interest rate fall by 0.6%… Correct?
Secondly, recommended hedging strategy would be futures or options if I have to choose between these two, given that following results (EIR) are calculated
Futures = 4.58%
Options increase by 1.1% decrease by 0.6%
94.25 4.56% 4.56%
95.25 4.9% 4.01%John Moffat
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Yes, that is now fine 🙂
humai
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Secondly, Sir recommended hedging strategy would be futures or options if I have to choose between these two, given that following results (EIR) are calculated
Futures = 4.58%
Options increase by 1.1% decrease by 0.6%
94.25 4.56% 4.56%
95.25 4.9% 4.01%John Moffat
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You would say that using futures would be better than using options at 94.25.
Using options at 95.25 would be better than futures if interest rates were to increase but there is the risk of interest rates falling in which case futures would be better.Appreciate that it is rarely possible to say that one is definitely better than another. The marks are for proving that you know how futures and options work and making sensible comments about the choice.
humai
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Sir likewise as you said above, if I write in the same way in Dec 15 Massie co that
“If interest rate falls by 0.5%, then hedging using collars gives the higher return than hedging using options at exercise price of 96.5. However, if interest rate increases by 0.5% then hedging using options at exercise price of 97 gives the higher return than hedging using collars, but it also gives the lower return than hedging using collars if interest rate falls by 0.5% in which case collars would be better”
However, examiner answer is slightly different. He has written following
“Option with 97 exercise price has higher average figure than option with 96.5 exercise price and can be recommended on that basis, as it worst result is only marginally worse than 96.5 option. There is not much to choose between them. Collar gives significantly worse result than wither of the options if interest rate rises because Massie cannot take full advantage of the increase. It is marginally better choice if interest rate falls. The recommendation would be to choose option with 97 exercise price , unless interest rates are virtually certain to fall”
humai
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So is my above answer correct?
John Moffat
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Yes – your answer seems fine 🙂
humai
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