Exam 24: Options, Caps, Floors, and Collars

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. Market interest rates are expected to increase 1 percent to 11 percent in the next year.If this occurs, what will be the effect on the market value of equity of Allright?

A hedge with a futures contract reduces volatility in payoff gains on both the upside and downside of interest rate movements.

What is the advantage of a futures hedge over an options hedge?

An FI buys a collar by buying a floor and selling a cap.

An option's delta has a value between 0 and 100.

KKR issues a $10 million 18-month floating rate note priced at LIBOR plus 400 basis points.What is KKR's interest rate risk exposure and how can it be hedged?

A bond call option gives the holder the right to sell the underlying bond at a pre-specified exercise price.

When interest rates rise, writing a bond call option may cause profits to offset the loss on an FI's bonds held in the portfolio.

The loss for a put option buyer is limited to the option premium paid.

An FI with a positive duration gap (longer asset maturities than liability maturities) will benefit by purchasing a call option position to hedge against interest rate increases

The maximum potential loss to a buyer of bond put options is limited to the premium paid.

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. At the time of placement, the premium on the options are quoted at 1¾.What is the cost to Allright in placing the hedge?

The combination of being long in the bond and buying a put option on a bond mimics the profit function of

The payoff values on bond options are directly related to the changes in interest rates.

The potential gain to the seller of a bond call option is unlimited.

Exercise of a put option on futures by the buyer of the option will occur if interest rates have increased.

Simultaneously buying both a bond and a put option on the bond produces the same payoff as buying a call option on the bond.

What is the advantage of an options hedge over a futures hedge?

Option positions that do not identifiably hedge an underlying asset or liability is referred to as a naked option

Open interest refers to the dollar amount of outstanding option contracts.