Exam 24: Options, Caps, Floors, and Collars

An FI manager purchases a zero-coupon bond that has two years to maturity.The manager paid $826.45 per $1,000 for the bond.The current yield on a one-year bond of equal risk is 9 percent, and the one-year rate in one year is expected to be either 11.60 percent or 10.40 percent.Either rate is equally probable. If the manager buys a one-year option with an exercise price equal to the expected price of the bond in one year, what will be the exercise price of the option?

The payoff values on bond options are positively linked to the changes in interest rates.

Buying a floor means buying a put option on interest rates.

A bank purchases a 3-year, 6 percent $5 million cap (call options on interest rates), where payments are paid or received at the end of year 2 and 3 as shown below: End of Year: 0 1 2 3 Cash Flow at end of year: - - Assume interest rates are 5 percent in year 2 and 7 percent in year 3.Which of the following is true?

An FI manager purchases a zero-coupon bond that has two years to maturity.The manager paid $826.45 per $1,000 for the bond.The current yield on a one-year bond of equal risk is 9 percent, and the one-year rate in one year is expected to be either 11.60 percent or 10.40 percent.Either rate is equally probable. Given the expected one-year rates in one year, what are the possible bond prices in one year?

The tendency of the variance of a bond's price to decrease as maturity approaches is called

An FI manager purchases a zero-coupon bond that has two years to maturity.The manager paid $826.45 per $1,000 for the bond.The current yield on a one-year bond of equal risk is 9 percent, and the one-year rate in one year is expected to be either 11.60 percent or 10.40 percent.Either rate is equally probable. Given the exercise price of the option, what premium should be paid for this option?

Assume a binomial pricing model where there is an equal probability of interest rates increasing or decreasing 1 percent per year. What should be the price of a three-year 6 percent cap if the current (spot) rates are also 6 percent? The face value is $5,000,000, and time periods are zero, one, and two.

There are regulatory reasons why FIs buy options rather than write options.For example viewing naked options as risky because of the large loss potential.

Unlike futures contracts, options are traded electronically through an option dealer network known as the Options Clearing Corporation (OCC).

Allright Insurance has total assets of $140 million consisting of $50 million in 2-year, 6 percent Treasury notes and $90 million in 10-year, 7.2 percent fixed-rate Baa bonds.These assets are funded by $100 million 5-year, 5 percent fixed rate GICs and equity. If Allright wanted to hedge the balance sheet position, what is the interest rate risk exposure and what hedge would be appropriate?

A digital default option expires unexercised in situations where the loan is paid in accordance with the loan agreement.

In April 2016, an FI bought a one-month sterling T-bill paying £100 million in May 2016.The FI's liabilities are in dollars, and current exchange rate is $1.6401/£1.The bank can buy one-month options on sterling at an exercise price of $1.60/£1.Each contract has a size of £31,250, and the contracts currently have a premium of $0.014 per £.Alternatively, options on foreign currency futures contracts, which have a size of £62,500, are available for $0.0106 per £. What is the foreign exchange risk that the FI is facing, and what type of currency option should be purchased to hedge this risk?

Which of the following is a good strategy to adopt when interest rates are expected to rise?

An FI manager purchases a zero-coupon bond that has two years to maturity.The manager paid $826.45 per $1,000 for the bond.The current yield on a one-year bond of equal risk is 9 percent, and the one-year rate in one year is expected to be either 11.60 percent or 10.40 percent.Either rate is equally probable. What is the yield to maturity for the two-year bond if held to maturity?

In April 2016, an FI bought a one-month sterling T-bill paying £100 million in May 2016.The FI's liabilities are in dollars, and current exchange rate is $1.6401/£1.The bank can buy one-month options on sterling at an exercise price of $1.60/£1.Each contract has a size of £31,250, and the contracts currently have a premium of $0.014 per £.Alternatively, options on foreign currency futures contracts, which have a size of £62,500, are available for $0.0106 per £. How many options should the FI purchase, and what will be the cost?

An FI manager purchases a zero-coupon bond that has two years to maturity.The manager paid $76.95 per $100 for the bond.The current yield on a one-year bond of equal risk is 12 percent, and the one-year rate in one year is expected to be either 16.65 percent or 15.35 percent.Either rate is equally probable. Given the expected one-year rates in one year, what are the possible bond prices in one year?

Banks that are more exposed to rising interest rates than falling interest rates may seek to finance a cap by selling a floor.

The potential gain to a buyer of bond call options is unlimited, even if interest rates decrease to zero.

Buying a cap option agreement