derivatives

pradeeppdy
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derivatives

Postby pradeeppdy » Tue Apr 16, 2013 10:00 am

Please explain how the combination of the long interest rate call option plus a short interest rate put option has a same pay off as a forward rate agreement ?

vnraghuveer
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derivatives

Postby vnraghuveer » Thu Apr 18, 2013 3:33 pm

Hi Pradeep
In the combination of long interest rate call and a short interest rate put, u realise a return of a futures contract and if the interest rate falls, an equivalent loss. It replicates a forward rate agreement ignoring the transaction costs.

vishnu.ftw
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derivatives

Postby vishnu.ftw » Thu Apr 18, 2013 4:21 pm

Consider this example:
You are long an interest rate of 5% with a call option. This means that you have a positive payoff, or you make money, when the interest rate rises above 5%. For this option, you obviously pay a premium of, let's say, Rs.100. Now, you ALSO sell a put option at interest rate 5%. This means that, as the interest rate falls lower than 5%, you lose money. In return, you receive a premium of Rs.100. So now, you lose if the interest rate goes below 5%, you gain if it goes above 5%, and you end up not paying a premium (since you receive Rs 100 premium from selling the put option, and you pay Rs 100 premium from buying a call option).

This is the same as buying a forward at 5%, where you don't have an option to NOT exercise the agreement, meaning you will lose money if the interest rate falls below 5% and you gain money if it rises above 5%, and you don't pay any premium on the agreement.

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

derivatives

Postby pradeeppdy » Sat Apr 20, 2013 11:25 am

hi lokesh,

I didn't understand yet so please make it.


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