FIN_PRODS_HULL_CH2_COMMISSIONS

[gargi.adhikari]

In Reference to FIN_PRODS_HULL_CH2_COMMISSIONS :-
Question # 1 : Why should we "Assume" an additional Commission of .75 % outside of the Commission Structure defined by Table 10.1
Question # 2 :
i) So we pay Commission while purchasing 1 Contract-> $ 30
ii) We pay a 2nd Commission while exercising the Option. In case we exercise the Option and "Settle in Cash" instead of an actual delivery of the Asset/Stock, Then-> The question of reselling the Stock should not arise...?
In that case, why should we consider a 3rd payment of Commission for Re-selling the stock..?
I might be missing an important here...Much gratitude for insights on this...

 

[David Harper CFA FRM]

Hi @gargi.adhikari I agree this is confusing ...

• With regard to Question #1, my perception (by which I mean that I am not certain) is that Hull is simply "introducing" the commission that is applicable to stock purchases or sales (as distinct from options), I am inferring (guessing) that Table 10.1 is applicable only to option contracts because the footnote refers to "contracts." So, to your point, I am assuming that he's just introducing the assumption that stock sales or purchases are a simple 0.75%.
  • The problem with this interpretation is that to exercise the option contract is to purchase at the strike price (K = $50) such that the exercise itself costs $50*100 = $5,000 (not $6,000) so that, if this assumption is correct, it seems to me that the exercise-and-sell commission should read: (0.0075*$50 + 0.0075*60)*100. Do you agree @gargi.adhikari ?
  • My alternative interpretation was that the same commission structure (Table 10.1) is being used also for stock sales/purchases, but this implies that the "+1% of dollar amount" does not apply. In this case, $45.00/$6,000 = 0.75%. See what I mean? But this seems less likely to me.
  • I just emailed GARP for clarification ([email protected])
• In regard to Question #2, he's just not illustrating a cash settlement, or even as far as i can tell his is not even illustrating a so-called cashless exercise (typical in ESOs, or actually employee NQSO). Rather, he's illustrating an (i) exercise (i.e., pay the strike to receive ownership of the shares) .... pause .... and then (ii) then sell the shares. Once exercised, the holder does not need to sell the shares. But notice he is comparing this to a sale of an option, so he's comparing two scenarios that each exit the position to cash. He's illustrating his point that the two-step exit (pay a commission to exercise, then pay other commission subsequently to sell) incurs more fees than just selling the option. I hope that's helpful!

 

[gargi.adhikari]

Thanks so much @David Harper CFA FRM for all the help on this one...
So...the Alternative Approach seems less likely as you very correctly pointed out as the 1% does not apply but also is it because the $-Amount of our trade(=$ 2400) does lie in that range($2500 to $10,000)...?

The 1st interpretation seems to be more intuitive to me at least...so we have 2 legs of Commission:-
Commission #1 : While Purchasing the Option Contract : .75% ( of the Exercise Price )= .75% ( $50)
Commission #2 : While Exercising the Option : .75% ( the Underlying Stock Price in this case..? or do we stick to .75% of the Exercise Price ) ...?

Also, the Commission structure stipulates a MAX- Commission of $30 per Contract for the 1st 5 Contracts. So again the above would violate the defined Commission structure as .75% ( $50) = $ 37.5 which exceeds $30. So do we just go with $30 as commission instead of .75% ( $50) ...? Same applies for Commission #2 as well...?

 

[David Harper CFA FRM]

Hi @gargi.adhikari Thank you for caring about details, truly!

Re "the Alternative Approach seems less likely ... because the $-Amount of our trade(=$ 2400) does lie in that range($2500 to $10,000)...?" You are referring to the initial purchase of 8 options contracts (cost = $2,400), but I meant that the exercise of one contract (in the second example) would cost 100 option * $50 strike = $5,000. Nevertheless, we seem to agree this is less likely than the purchase/sale of stock has its own schedule.

But with respect to the first approach (and my interpretation), please note there are three trades:

1. Purchase of "one call contract with a strike price of $50 when the stock price is $49. We suppose the option price is $4.50, so that the cost of the contract is $450." When we apply Table 10-1, the commission is $20 + (2%*450) = $29.00, but Hull says the max/min rule applies, so the commission (on this "first contract") is $30.00
2. Exercise of the option contract; i.e., purchase of 100 shares (with a current price of $60.00) for the strike price of $50.00 per share. Total exercise cost = $5,000. (I don't understand why the commission here isn't 0.75% * $50).
3. Subsequent sale of the 100 shares presumably at the same price of $60.00, then commission on sale is (0.75%*$60) per share.

But with respect to (2) and (3), if the schedule is different for share sales/purchases, I am not expecting the $30 min/max to apply .... Thanks!

 

[gargi.adhikari]

Thanks so much @David Harper CFA FRM for sharing your insights above. I have a few follow up questions/clarifications to make sure I interpret GARP's verbiage as correctly as I can...
So for Point # 1 , my question is that should the Max Contract Price of 30$ apply only if the Calculated-Commission via the Commission Structure defined by Table 10.1 is exceeds $30..? In case the Calculated Commission is < the Max Allowed Limit of $30, then , the Commission would just be the lower value which is $29.00 as in our case for the Purchase of the Contract.

For Point # 2 : I agree with you totally and am fuzzy ...as to why the Commission should not be 0.75% * $50....clarification on this point would help a lot in case such a question pops up in the exam...

For Point # 3: Totally on the same page on this one ..

 

[David Harper CFA FRM]

Hi @gargi.adhikari

Re Point #1: that is not how I interpret Hull's footnote (sorry, and I could be wrong; as you know, we are both a bit confused by the details here!). Hull's commission structure is attached with this footnote: "Maximum commission is $30 per contract for the first five contracts plus $20 per contract for each additional contract. Minimum commission is $30 per contract for the first contract plus $2 per contract for each additional contract." So, how I read this is that the first step is to compute the commission per the three-tier schedule (e.g., $20 + 2% of dollar amount) but the second step is to check the {min, max}. I interpret this phrase as follows for the fist seven contracts:

1. {30, 30}
2. {2, 30}
3. {2, 30}
4. {2, 30}
   
5. {2, 30}
   
6. {2, 20}
   
7. {2, 20}

So, as Hull says, the first contract has a commission of $30.00 regardless because that's both its minimum and maximum. I admit, to your point, this leaves unresolved certain details actually! It's still not a complete rule set, in my perception. But note that Hull's example arguably works: "Table 10.1 shows the sort of schedule that might be offered by a discount broker. Using this schedule, the purchase of eight contracts when the option price is $3 would cost $20 + (0.02 * $2,400) = $68." So there he has simply applied the rule of the first trade. Then we can consult the {min, max} and my interpretation would be to summarize the minimum of 8 contracts as $44.00 (ie, $20 + $2*7) and the maximum as $210 (i.e, $30*5 + $20*3), such that the calculated $68.00 is used because it falls within the {min, max} for eight contracts. But I'm not saying that's the only way to interpret this table

Re: points #2 and #3: yes, agreed, that's why (candidly) I sent a copy of this thread to GARP. I'll post if/when I get a reply. Thanks!

 

[gargi.adhikari]

Thanks so much @David Harper CFA FRM for elaborating the above - very grateful - I see now where I was going wrong misinterpreting the given specs and how Hull's example fits the rule described...One small clarification though ...by any chance, did you mean the Min Value to be $54.00 (ie, $30 + $2*7) instead of $44.00 (ie, $20 + $2*7) ...?

 

[David Harper CFA FRM]

Sure thing @gargi.adhikari I think I meant a blend of ours sorry ... if the minimum is "$30 per contract for the first contract plus $2 per contract" then $30 + 2*7 = $44, so my $20 is wrong but maybe the 44 is correct (?). Thanks!

 

[gargi.adhikari]

@David Harper CFA FRM Thanks so much ...lol....yes..i agree with the blend of ours ..lol...my arithmetic was always bad but this was pathetic even by my standards ... so dependent on calculators..damn... lol