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ACCA AFM | Interest Rate Hedging | Collar Options on Interest Rate Futures | Lecture 45

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Summary

Core Theme

This content introduces and explains the "collar" strategy in options trading, specifically for interest rate futures (IRF). A collar is a combination of options designed to reduce the premium cost of hedging, but it limits potential upside gains.

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So I'm going to go through something

very interesting right now which is a

new strategy but not totally new but

it's just a blend of what we've looked

at before and is options. Color is a

form of options but a combination of

options. So I call it option combo that

is just from me to for you to remember.

is a combo of options and I'm going to

show you how this works. Remember a

typical option in IRF. So we're looking

at color for interest rate futures.

Remember we've looked at options. In

fact, we've looked at interest rate

futures. We've looked at options on

interest rate futures. Now this is a

caller on interest rate futures.

And I'll explain but please follow me

slowly. Let me quickly take your mind

back to the last video where we spoke

about options on IRF. When we said for a borrower,

borrower,

this borrower is worried about something

interest rate.

That's his problem.

That is worried. So which means this guy

is saying that I don't want to pay more

than a certain amount of interest rate.

So because of that he put a cap. And how

will he put that cap? Usually he will

put a cap by

buying an option. And what type of

option do we agree? Because it's a

borrowing which means he wants to sell a

bond. So he will buy an option that is

called put. So he's going to buy put on

interest rate future.

So with this he has put a limit to

interest rate. So if interest rate goes

beyond this level

he's not worried. He's fine. And as it

is by the time interest rates start

coming down this guy has access to

this unlimited benefit.

So take for instance if he has fixed his

rate as say maybe the strike price is

10% here. If this goes to 7 8 5 3 2 can

throw away the option and just go to the

market and enjoy the full benefit

benefit of what the market is doing. He

has access to this and please take note.

Yes, access to unlimited benefit and you

can discard the option. But if the op if

the interest rate decides to go upward

as well, he can just limit his exposure

to that strike price and exercise. So

you know that here this guy will exercise.

exercise.

Yeah. To take care to use this particular

particular

rate. However,

at this place, you will not exercise.

And why will you not exercise? Because

you want to take the full benefit of the

spot rate, which is the market. Because

the market is favorable.

The same thing for deposit that is

worried about decreasing rate. What the

guy would do? So, let me just quickly do

that. For a deposit,

the guy is worried about decreasing

rate. So if he's worried about

decreasing rate, usually what he does is

he's going to buy an option as well. But

this time he's going to buy a floor

which is a call option and options to

sell because an investor to buy rather

is an option to buy because an investor

want to buy a bond. Yeah. So and what

does that mean? If he buys a bond, he

wants as much interest as possible. So

his fear is that he doesn't want

interest rate that is low. So because of

that he will buy a flaw. So this is a flaw

flaw

which means his own protection is

interest rate not coming down. So if

interest rate decides to come down he

will exercise because he has already

Yeah. Which means anything that goes up

here, the guy will be excited because if

the market is here more than his strike

price, it will exercise

cuz no it will not excine. So this will

not exercise because it will just take

care of the market. It will just go for

the market straight away. This is where

it will exercise. Yeah, it will not

exercise because this is the worst case.

Anything higher is good for him. So here

to that unlimited benefit

while also

fixing his loss.

That's his maximum loss that he has

fixed there.

Now this looks fantastic but there's a

disadvantage and that's why caller came

and the disadvantage is the fact that

you are always buying whether a call or

a put you are always buying and when you

So the disadvantage is that this might

and that's what gave rise to that

strategy to reduce premium. So to reduce

that premium

the color came up.

Want to reduce your premium then you

have to use a color strategy.

for color strategy. What this is saying

is that instead of you to always buy,

why don't you do two things? Yeah. Which

means yes, you buy your normal option

which means for borrowing buy your put

for deposit buy your car.

Yeah. So buy your normal option. Yeah.

And you buy your normal option. Yes. You

will pay your premium as normal.

But in addition, why don't you establish

a side contract on the opposite that you

are selling? So sell the opposite.

So you sell opposite

option. So which means for a borrower

that has sold I mean that has bought a

put as a normal option. Yeah, borrower

you have bought a put.

You come here on the opposite and do

what? sell a call at a different strike

price, definitely lower strike price.

You will see. I'm going to work an

example to show you in practical sense

how it works. Yeah. But remember, once

you sell an option, what do you get? You

Receive a premium. So which means if you

pay a premium and you receive a premium

then definitely you have reduced net premium

and that is color strategy. It has it

own disadvantage and as you will see in

the example I'm going to show you now

the problem is that when you use a

collar you will lose this maximum

access. You going to have a limited

access. You can have unlimited benefits

on the upside and that is disadvantage.

You are restricted.

You see how restricted to certain upside

and what what do I mean by that? Let's

let's use borrower for an example which

is a popular one even in question they

tend to ask for borrower more than

deposit but they can ask for deposit as

well. So normally what are we going to

do if you have a borrower? Borrower is

someone that want to borrow money

someone that wants to borrow money is

someone that wants to sell a bond. So if

you want to get interest rate futures it

will be interest rate futures to sell a

bond. So if you want option on that

that's an option to sell IRF and what is

So let's say for instance that is at uh

let's say at 7%.

So which means that is the cap for the

guy 7%. So this is the maximum interest

he will pay. the maximum interest expense

expense

will be because anything above that you

will exercise this option and it will

pay 7%. Right?

So with this one [clears throat]

this is a this is a put option that you

So you are long

on put option. What that means is that

uh you've bought remember terminologies.

So it means by you bought a put option

So you must have paid premium.

But at the same time to reduce this

premium then you need to come down

and set another level and say okay this

such that you're doing such that the

likelihood of the person exercising is

very slim because you know that

your upside normally without this 5%.

If you don't have this 5%

it means that the whole of this place

once the rate keeps coming down is just

for your benefit because you will just

ignore this 7%. And go with the market

by the time you decide to draw this line

and say you want to sell an option at

5%. Remember you have to sell an

opposite option which means you're going

to sell a call.

And I'm sure you know what that means.

Once you sell a call, yeah, say to party

B, you know what that means? It means that

that

you gave So if this is A, let's say this

is party A. Yeah. It means that A has

given a right to B, right?

right?

A has given a right to B, a right to

party B

to buy.

Remember is a call. So part B now has a

right to buy IRF.

Yeah. At what rate?

At 5%. So which means part B will

receive interest income inflow

at 5%.

So part party B is using this 5%

as its own worst case scenario. So which

means once the interest rate is above 5%

party B will not worry you and that is

why this portion

is your own limited

upside that you can have. So your upside

is limited to this spot as party A. So

this limited upside for party A.

Normally it would have been the whole of

this downward trend but because of this

transaction that's not the case because

anytime the interest rate is around here

but B will exercise

anytime so take for inance if interest

rate is 3%.

A cannot say he wants to do market at 3%.

3%.

He can't dict that benefit. Even if he

does it, let's even say he does it, you

will see how he's going to nail out. So

if you say he want to exercise which at

3%, so if a exercise at 3%, then he has

a benefit of 4%. That's 7 - 3, right?

But remember

what happens to party B. Party B has

already said my worst case scenario for

my income is 5%. So if Marcus is doing

3% then he's going to exercise and he's

going to come for party A to pay him the

net loss because he's going to be

getting 3% then party A will have to

make it up for him at 2%. So which means

party A will lose 2%. To be and what is

the net for party A 2%. Which still goes

back to 7% less 5%. So your upside as a

caller seller

once you do the strategy caller just

know that your upside is limited.

I think the same thing opposite for

deposit. If you look at deposit is the

same thing similar.

Can try and do it yourself before you

look at the way I'm going to do it.

Yeah, it's just opposite because

normally what is the problem with the

deposit guy? Deposit guy wants his

interest to go up. So he's afraid of

coming down which means what he's going

to do is that this guy will want to fix

his flaw.

Yeah. So let's call it X not. So which

because

if rate goes below that

and you collect his X not. However,

However,

he's supposed to enjoy unlimited upside,

but because he wants to reduce his

premium, he will decide to sell

something there.

And what he's going to sell, remember

for a deposit, what you are buying normal,

normal,

yeah, this your normal

Yeah. So which means this time around

for a caller to complete going to sell a

put. And what is selling a put means?

Selling a put to party B means that you

have actually given

a right to party B

to sell a bond which means you will pay

interest. Part B will pay interest at a

fixed rate. So which means part A will

not pay interest more than this level.

So when interest goes beyond this point,

party A will have to compensate party B

for that. And that is why party A will

be limited to this upside.

And that is why color

can be

annoying in as much as it's trying to

minimize your premium because of the

inflow of premium you get by selling

those options. Likewise, if the market

turns to be very good, your flexibility

is not as flexible. That is the summary.

I'm going to quickly just do this

question to drive it even further home.

Good question here. Take one second,

look at it, and see where I'm going to

deal with it quickly. Yeah, here we have

two scenarios. If the base rate rises to

9.5% and future prices move to 90.2% uh 90.2

90.2

we should calculate the effective

interest rate for the company using

color. Remember they want to use color.

So and what is happen is they are trying

to borrow to borrow. So which means we

have normal

is going to be the normal

expectation. And what's the normal

expectation? So we're trying to set up

the color now. Yeah right. So to set up

the color, let me say this is color.

Yeah, the normal is to buy put.

Yeah, if you're setting up a color,

don't look for cheapest strike price

because your

strike price

in a collar for the put has to be higher

interest rate. Don't go for the don't go

for a lower one because that will make your

your

color to be defective. So you buy put

you have 92 and 93 there. So the

interest rate here is 92 which is 8%. So

buy put 92

and um that is 8% to make it clear and

you do the opposite and sell call at 93.

Yeah. And that is 7%. Yeah. But are we

using March or June? If you look at the

question the transaction will happen 1st

of January. So we need to use March. We

don't need to use June because March

option will expire end of March. So

we're good. We don't need to

think about June in that sense. So which

means in terms of our premium for this

color, our premium will be

we're paying 93 as uh 92 for for putm.

So pay 0.2%

0.2%

and we'll receive

So which means

in terms of net premium this is going

out and this is coming in. So our net

premium in that sense will be let me put

on calculator that's 2 minus.15

That's the premium situation.

Yeah. But are we going to exercise now

that we have this option there? Let's

look at it. What is the outcome of the

collar? If interest rate goes to 9.5%.

That is already higher than our strike

price of 8%. Yeah, remember what we have

is it this is our cap 8% and we did

color at 7%. So now interest rate has

gone to 9.5%.

So which means at this point we will exercise.

exercise.

Will this guy exercise? No, he will not

exercise because this is the worst case

scenario. If market has gone to 9.5, we

rather stick to a market and ignore. So

which means is a money for us but it's

out of money for the guy for his own

other side. So which means premium is

sealed. We have that we exercise at 9.5

market. So definitely we're going to do

our normal buying and selling of

features. And that means

92 was our future. So we initiated at 92

and we close at 90.2.

So which means we're borrowing at 8%,

we're paying at 8%.

Yeah. And we are actually receiving at

uh 9.8%.

And that will give you

profit of 1.8% 8% is same as 1.8 that

you have here. Yeah, this is one way of

doing this another way of doing it.

Yeah, but for interpretation I prefer to

do the second way so that you can be

clear to you. Remember this is boring.

Yeah, boring at 92 when you start when

you buy the future initially. Now this

is when you uh this is when you sell the

future. Sorry, you sell the interest

rate feature here and you buy back here

because the option you remember the

option is a put option option to sell

the bond. When you sell bond you pay

interest on it because you are raising

fund right so now we have net 1.8% 8%

there we have to keep it. So let's put

everything together. Base rate. So the

rate transaction is the third leg.

The rate transaction is 9.5 base. So

which means to get the total interest

rate for a question A. So we have the

rate transaction at base 9.5%.

The question told us that there's a

margin of plus 2%. Which is fixed.

That's the margin. Then from um

feature closing we made 1.8. So that

will help us is a gain. So that will

reduce our cost. Uh on premium

unfortunately is a

liability for us net liability. So we

need to pay 0.05%.

And when we put all of this together

let's see what it gives us. So we have

9.5 + 9.5 here + 2

+ 005 11.55 - 1.8

and that gives us 9.75%.

Easy. That's the effective interest

rate. Yeah. And this is what we apply to

the principal to get the net position.

That is A. Similar

process we're going to use for B. And

for B what is going to happen? Remember

what happened? This same diagram 8% 7%.

That is our own cap and we sold call at

7%. Unfortunately, market came and life

happened. And what happened? The

interest rate in reality decided to go

to something much lower, 4.5%.

At 4.5%

we will definitely forget about our own

option because we already said the

maximum we want to pay at 8%. We will

not exercise that kind of option and

start paying at 8% when market is doing

4.5%. So that is gone. We're not going

to our option is useless.

But our premium we paid it is a some

cost is still there. So which means

remember this net will still be

relevant. So we're still going to bring

it down. So premium

let me call it net premium is still

available at 0.05%

cost. Yeah.

And real reality of markets will also

happen. Reality is uh 4.5%

plus margin of 2% that is always fixed

So we know the net premium, we know the

reality. Now we need to know what is

happening to the RF interest rate

features. What is the next situation? So

in this case we already said for us our

IRF will expire but the IRF for this guy

will be exercised because the market is

doing below his strike price and because

of that he will take advantage of IRF

and for him to take advantage of the

IRF. Remember what happened was the fact

that he bought IRF at strike price of um 93.

93.

I think we sold at 93. Yes. So we did

call at 90. That's why it's 7%. Yeah. So 93

93 was

was

when he actually bought that call which is

decide to exercise. Then he bought at 93

and you would need to sold you need to

sell rather at what the market is doing

on the future which is now 96.1.

So you need to close that feature. 96.1.

Yeah, if you look at it this way, that

will give you a difference of 93 minus 96.1.

96.1.

That's 3.1%.

But the reason why I don't like explain

like this with these numbers is you

might be stuck to know whether it's a

gain or

or loss. But the way to know is the fact

that if he's exercising is a gain,

right? And if it's a gain for him, it's

a loss for us. That's one way to look at

it. One way to look at it is that when

he bought, he bought means that he's

going to receive interest inflow at 7%.

So that's you get inflow at 7%. And when

he's selling, he's going to be paying at 3.9%.

3.9%.

So he's left with positive 3.1%. That's

another way to look at it. Okay. So if

the guy is making positive, definitely

we are making negative. And that is why

for us it would be a negative 3.1. So

that is a I'm call plus to avoid

confusion but I'll just call it 3.1

because I've measured all the other cost

at positives. So if you add all the cost

together we have 05% which is our net

premium plus the market doing 4.5% base

then that will be a 2% margin for the

company risk and the IRF will close at

additional loss for us 3.1%.

So when we add all of these together

quickly, 005 + 4.5

+ 2 + 3.1

that gives us 9.65%.

So if market decides to go that route,

then our effective interest rate is 9.65%.

9.65%.

despite the use of our collar. So you

see that not too far away but it can

give a different result depending on our

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คำบรรยาย YouTube:ACCA AFM | Interest Rate Hedging | Collar Options on Interest Rate Futures | Lecture 45