Question

Suppose that the pension you are managing is expecting an inflow funds of RM 100 million next year and you want to make sure that you will earn the current interest rate of incoming funds in long-term bonds.

1. How would you use the options market to accomplish this goal? (4m)
2. What are the advantage and disadvantage of using an options contract rather than a futures contract? (6m)

Answer 1

i:

You would buy a call option on long term bond for next year expiry and at a strike price which will result in an interest rate required.

ii:

Advantages of options are we are only spending the premium requirements for the long term bonds and in case of black swan events, the maximum amount that we will loose will be only the premium. Whereas on the upside we can enjoy as much profit potential as per the appreciation of the asset. Also there is no need for margin requirements compared to futures or MTM settlements for option Buying.

The disadvantage is the payment of premium and during highly volatile situatuion , the premium might be higher and cannot be justifiable compared to the strike price we are taking the contract.