Question

(a) Explain why would a company engage in an interest rate swap over other means of managing risk?

(b) The AT Corporation is holding a large number of XXY Bank shares in an investment portfolio and wishes to protect the value of the investment. The XXY Bank shares currently trade at $22.00. The AT Corporation buys a put option with an exercise price of $20.00 per share and a premium of $0.85 per share. By entering this option strategy, explain whether the AT Corporation will exercise the option if the spot price is above or below the exercise price. [You are required to clearly define a put option, spot price, exercise price, and premium - in order to explain your final answer].

Answer 1

Solution of Part (a) is uploaded through picture.

(b) Firstly,

Put option is a stock market instrument which gives holder a right(not obligation) to sell asset at a specified rate (i.e , excercise price)

Excercise price is price at which holder of an put option has right to sell asset.

spot price is the current market price at which asset can be purchased or sold with immediate delivery.

Option Premium is the current price of the option. It is the income of the seller of an option.
Now, AT corporation has shares of XYZ bank which is current selling at $ 22 . Company buys a put option with excercise price of $ 20 & option premium of $0.85 each.
This means that if in future date, AT corporation has a choice of selling the shares at $ 20 but it is not obliged to do that.
when in future , if the spot price will be above $ 20 , then company will not excercise the option to sell at $ 20 because it can sell in open market with more price.
but if the spot price will be less then $ 20 , ofcourse the company will excercise the Option to sell at $ 20 because to excercise the option will be more profitable.