Steward Mink Case Scenario (Derivatives)

Q. Compared with the collar created from the Texmaco loan and the options described in Exhibit 2, which of the following combinations of option exercise rates will provide the lowest cost collar?

  1. 4.0% put and 6.5% call
  2. 4.0% put and 5.5% call
  3. 5.0% put and 6.5% call

B is correct. Both the put and the call have lower exercise prices than the collar being proposed. Hence, for the same underlying, the cost of the put with an exercise of 4% (instead of 4.5%) less the premium received from writing the call at 5.5% (instead of 6%) exercise should be lower than the collar being proposed. Mink pays less for the 4% put and receives more for writing the 5.5% call.

A is incorrect because Mink will receive less for writing the 6.5 percent call than writing the 5.5 percent call.

Don’t get it, shouldn’t be A since writing a call which is in the money (strike 6%) cost more than a OTM option?

If your strike is 6%, then the 5.5% call is in the money so you would receive more writing it than writing an out of the money option (6.5%)

Oh man, I am wondering how could I ask this. My reasoning above was right but ended to the wrong answer with the call. Typical example of when one should put down the pencil and take a day off when had a though day. It could avoid to start making confusion and stupid/no reasoning properly. :slight_smile: