Beginner Question - Choosing the best strike price

[joanne_peacemaker]

Hi,

This is in regard to an assignment question. The firm wants to buy options to protect themselves against a rise in Interest rates. Option strategy is

Purchase 200 PUT Options with Strike Price ____

Now I have shortlisted the following position that I can take, and I have to choose one of them.

The firm is interested in hedging from Interest Rate rise and hence attitude to risk is to minimise risk. I would like to know what sort of factors should I take into account before choosing one of these positions? In other words, on what basis should I deside which is the best position out of these?

Thanks
Joanne

 

[TheBramble]

A higher interest rate is likely to lead to higher call option premiums and lower put option premiums, reflecting the cost of funding. A call option buyer can defer paying for the underlying index until expiry of the option and invest the funds in other interest-earning instruments during this period.

As the interest rate rises, more interest can be earned on the funds. Hence, a call option is worth more to the option holder. So you'd be better off buying Calls than selling Puts. As for buying Puts...

However, if you're stuck with buying Puts, I'd go for the lowest priced strike and series based on that depreciating less quickly than the other stirkies/series.

Bear in mind, interest rates have the smallest impact on premium pricing.

 

[joanne_peacemaker]

Hi,

Thanks for the advice. I am sorry, I should have mentioned that I will have an underlying cash market position. I am using PUT options as the firm will need a loan of £10 Million in 6 months time. So lets say the above rates are for 1st Oct 07, and the loan will be taken on 1st April' 08. The firm is using options, to hedge against the risk in the cash market, that will come because of Interest Rate rising. Hence, the PUT Options. If the rates dont go up and instead go down, the benefit will be recieved in the cash market. That is what the idea is. Also for the purpose of the question I am using "3 month sterling" options.

So based on this, what would should be the best option out of the above ones and what sort of factors should I take into consideration, before choosing one of the above options?

Thanks for your help
Joanne

 

[TWI]

I see no reason for you not to do ATM with 6month expiry.
Time value is fixed so really you need to take into account implied volatility as that is what you are paying for. I would also calculate how what premium you are paying equates to basis points interest on your loan as by paying premium you are spending in the same way as increasing the rate you will pay.

 

[r.w.]

One way of dealing with the question could be to plot the p/l functions for the hedged positions in the same graph (one per choice of option, so six graphs in the same diagram) and then weigh premium paid against hedge obtained to arrive at your choice.

 

[joanne_peacemaker]

Hi,

Thanks for the replies.

TWI - Indeed, I intend to choose one of the ATM options. From the table above, that leaves me with the last four options. What would be the best way to choose one of these, i.e. what sort of criteria should I use in my evaluation?

In terms of Volatility and Delta, we have been asked to ignore these, as this is supposed to be an introductory assignemnt.

I would also calculate how what premium you are paying equates to basis points interest on your loan as by paying premium you are spending in the same way as increasing the rate you will pay.

How do you recommend doing this?

R.W: That sounds interesting. Do you know if I can find an example of this or how to go about doing this?

Thanks for all the help
Joanne

 

[r.w.]

Hi,


R.W: That sounds interesting. Do you know if I can find an example of this or how to go about doing this?

In Excel , plot the value of the hedged positions at expiry as a function of the rate.

 

[TWI]

All I meant was that you are paying for an insurance policy by buying the put. This will have an associated cost which you should equate to a cost in your forward loan. Assume you did not take the hedge? How much would interest rates need to move to cost you the same as you are paying in premium? Is it a reasonable hedge as a result of that?
Since the option will be ATM and you are gonna have 6months to expiry whatever option you choose the most significant component of the price will be the implied volatility that you are paying for the option. Implied vol is a market like anything else and it gets bid up and smacked down just like price of an underlying. I would be sure you understand the difference between implied and historic vol.