Could someone please explain why, for calculating Effective Annual Interest Rate, there are different treatments for calls and puts, even though in both cases the individual takes a long position:
For a Put option,
Effective Interest = Interest on Loan + Put Option Payoff, and
Effective Loan Proceeds = Loan + Put Option
For a Call option,
Effective Interest = Interest on Loan - Call Option Payoff, and
Effective Loan Proceeds = Loan - Call Option
If you are referring to questions that are from the mock exam:
Because in the first scenario, you are giving out a loan,
but in the second scenario, you are taking a loan
Hey Norest - I believe it’s because the two cases are for different parties. You would purchase a call option if you want to hedge against an increase in rates. You would only want to hedge against an increase if you’re paying interest. and therefore borrowing funds.
You would buy a put to hedge against a decline in rates, which you would be concerned about if you were receiving interest, or lending.
When you borrow, you subtract the call premium, because you’re looking at your net inflow from the transaction (we’re assuming you’re not using additional funds to purchase the call). Think of it as you used some of the borrowed money to buy the call.
When you lend, you add the put premium to the principal loan amount because they are both outflows that the bank is making, and so combined, represent the total cost to the lender.
This make sense?
Thanks for the succint explanation!