Question

12. You wish to acquire a eurodollar interest rate option for LC $6 million in March and want to lock in a deposit interest rate of 7½ percent. You look in the options market quota. tions under Mar and find the following information: LC Strike Price 9200 9225 9250 9275 Calls-Settle 0.50 0.41 0.54 0.26 Puts -Sette 0.05 0.30 0.15 0.18 at 1- et of What will be the cost of using the options market to he the interest rate risk?

Answer 1

In order to hedge against risk due to decrease in interest rate, an investor looking for getting assured interest rates on deposits should purchase a call option. This option gives its buyer the right,but not an obligation to buy futures contract at today's price ( strike price ). Here is how it works:

Let's assume strike price is 9200, with call option at 0.5.

In the event of reduction in interest rate, the futures contract price will rise above strike price i.e. 9200. Let's say 9250. The buyer of option would then sell the existing contract at 9250 and exercise his/her buy option thus getting contract at a cost lower than 9250. Thus, investor can use the gain from the option to offset lower interest rate.

However, if interest rates were to rise, the investor won't exercise his buy option as the futures contract price would have fallen ( Let's say 9100). The investor will thus allow option to be lapsed, while benefitting from higher interest rates.

Thus, we have seen that investor is able to limit his downside by acquiring a buy option, for which he has to pay option premium, which is the cost of hedging.

Now, we come to the cost of hedging to lock an interest rate of 7.5% on $ 6 m.

Since, each Eurodollar futures contract represents a $ 1 million time deposit with a three-month maturity, one can hedge by acquiring 6 contracts.

The relevant contract for locking interest rate of 7.5% is strike price of 9250 since strike price reflects 100 times ( 100- 90-day interest rate). The corresponding entry under Call- Settle column is 0.54.

Now, each bps represent $25, hence call option can be acquired at : $25x 0.54 x 100 = $ 1350

Thus, the investor would need to pay the cost of $ 1350 x 6 = $ 8100 for locking $ 6 m at interest rate of 7.5%.

However, since value of call option at strike price of 9225 is lower compared to strike price of 9250, it is preferred. Each call option contract can be acquired at :  $ 25 x 0.41 x x 100 = $ 1025

Thus, the investor would need to pay the cost of $ 1025 x 6 = $ 6150 for locking $ 6 m at interest rate of 7.75%. Hence, investor should acquire this option as it offers lost of hedging along with higher lock-in rates.