Can someone help answer the post in the re-directed link below? Repost his question here for your convenience:
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/9992367
I’m struggling with understanding the basic concepts of this - what exactly doe sit mean to have an option on a forward contract? I have the right to enter into a forward contract at X price?
Can someone explain this to me with real numbers:
Portfolio 1: 1) A call option on the forward contract with an excercise price of X that matures at time T on a forward contract at Ft (???) 2) A pure discount bond that pays X-Ft at time T.
WTF?
Option on forward contract means you have the right to enter into a forward agreement at specific strike price at maturity of option. Strike price is the interest rate for the specific maturity forward agreement. As you have a call option, if at maturity the interest rate ( forward rate for your forward agreement) is higher than your strike price ( your interest rate specified in option) then you will exercise the option and would pay that interest to the lender rather than marker interest rates prevailing at that time. Effectively, you earn Interest saving of = FT- strike price.
Example strike price is 5 percent Libor for 3-month and maturity of option is 3 months where if you exercise you will enter into forward agreement for 3 months from the date of option maturity. If at maturity of option, your market prevailing interest rate is 7 percent, you effectively saved 2 percent on a notional principal. This is the basic understanding on option on forwards.
Then include the principles of put call parity. X-ft is the saving on interest rate multiplied by notional principal discounted at relevant discount rate. This is dummy cash flows which you should invest in a bond to get x-Ft at end of forward Agreement.