Reading 8 Example 5 mismatch in character

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Hello Guys
in question 1
I don’t understand why 10 millions above the strike price of the collar will be considered a loss on the collar
in question 2
the mismatch in character appears before the expiration of the collar if the different instruments used to construct it are taxed differently?
 
Hello guys
correct me if I’m wrong
we have two ” assets”. The hedge and the concentrated position they have an opposite P&L (as we are hedging the market value of the concentrated position)
this explain the answer in Q1
they can be taxed differently by the taxing authority this can implies a mismatch in character
but what about the mismatch in character at the inception of the hedge (premiums) ?
in question 3
I ’ m really lost
the underlying = stock options
the hedge = the collar (put & call)
at the expiration of the collar the stock options will be called so there is really no income ?
 
when exactly does the mismatch in character occur? Did you figure that out? It does NOT occur when the collar is entered into.
At the time you enter into the hedge (collar to offset your stock option position) there is absolutely nothing that has happened. You paid the premium to buy the collar (but since you entered into a collar where a call is sold and a put is bought - more often that not you have a zero cost collar). There is nothing else as far as I can see. Why would someone stop you from spending your money?
When the stock options rise in value and you get the money - that is when the hedge also loses value. Now the hedge has a loss - which the tax authority will allow you to offset against a gain on some other transaction - but not against the rise in value of your stock options. Now is when the mismatch in character occurred.
 
Thank you CPK
I have two issues
1) as you said there are two contracts ( the put and the call) which premium offsets each other but
the premium receive on the call is taxed as income and the premium paid for the put is not deductible but added to the cost basis underlying. So We may be two different rates and different timing. The tax due will be paid at the end of the fiscal year and reduction in taxable gain will occur when the underlying is sold.
3) the value of the stock options is beyond the collar then the call is exercised. I give my stock options to the dealer
but for reporting purposes :
I must consider a gain for the underlying which will be taxed at T1
I must consider a loss on the collar that will be taxed at T2
This is my understanding of the answer giving by the curriculum !
 
For your part 1 - not sure that a Collar is treated as a Call and a Put separately in Tax terms. I am no expert and never thought of this difference when I studied, I will be honest.
For Part 2 - the tax at T2 cannot be used to offset the tax at T1 - due to timing difference as you have shown. Additionally even if the timing were somehow the same - the tax authorities would stop you from using the offsetting loss.
 
Thank you CPK
when there are two contracts ( exchange traded ) you must bear this mismatch in character
when you can have on OTC contract you must bear the counterparty risk
 
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