Question 1

The outstanding number of put or call contracts is called

Accepted Answer

A) open interest. 
B) pull-to-par. 
C) cap. 
D) floor. 
E) collar. 
A) open interest. 
B) pull-to-par. 
C) cap. 
D) floor. 
E) collar.

Question 2

What reflects the degree to which the rate on the option's underlying asset moves relative to the spot rate on the asset or liability that is being hedged?

Accepted Answer

A) Credit risk. 
B) Basis risk. 
C) Hedge risk. 
D) Volatility. 
E) Open interest. 
A) Credit risk. 
B) Basis risk. 
C) Hedge risk. 
D) Volatility. 
E) Open interest.

Question 3

CBOT catastrophe call spread options have variable payoffs that are capped at a level of less than 100 percent of extreme losses.

Accepted Answer

A) True 
 B)False

Question 4

An FI would normally purchase a cap if it was funding fixed-rate assets with variable-rate liabilities.

Accepted Answer

A) True 
 B)False

Question 5

The concept of pull-to-maturity reflects the increasing variance of a bond's price as the maturity of the bond approaches.

Accepted Answer

A) True 
 B)False

Question 6

For put options, the delta has a negative sign

Accepted Answer

A) since the value of the put option falls when bond prices rise. 
B) since the value of the put option rises when bond prices rise. 
C) since the value of the put option falls when bond prices fall. 
D) since the change in interest rates is equal to the change in the interest rate on the bond underlying the option contract. 
E) to adjust for basis risk. 
A) since the value of the put option falls when bond prices rise. 
B) since the value of the put option rises when bond prices rise. 
C) since the value of the put option falls when bond prices fall. 
D) since the change in interest rates is equal to the change in the interest rate on the bond underlying the option contract. 
E) to adjust for basis risk.

Question 7

Interest rate futures options are preferred to bond options because they have more favorable liquidity, credit risk, and market-to-market features.

Accepted Answer

A) True 
 B)False

Question 8

Identify a problem associated with using the Black-Scholes model to value bond options.

Accepted Answer

A) It assumes short-term interest rates are constant. 
B) It assumes that commissions are charged. 
C) It assumes fluctuating variance of returns on the underlying asset. 
D) It assumes that the variance of bond prices is constant over time. 
E) All of these. 
A) It assumes short-term interest rates are constant. 
B) It assumes that commissions are charged. 
C) It assumes fluctuating variance of returns on the underlying asset. 
D) It assumes that the variance of bond prices is constant over time. 
E) All of these.

Question 9

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

Accepted Answer

A) True 
 B)False

Question 10

A contract whose payoff increases as a yield spread increases above some stated exercise spread is a

Accepted Answer

A) put option. 
B) call option. 
C) digital default option. 
D) futures option. 
E) credit spread call option. 
A) put option. 
B) call option. 
C) digital default option. 
D) futures option. 
E) credit spread call option.

Question 11

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?

Accepted Answer

A) The balance sheet position is exposed to interest rate increases; use a short hedge. 
B) The balance sheet position is exposed to interest rate increases; use a long hedge. 
C) The balance sheet position is exposed to interest rate decreases; use a long hedge. 
D) The balance sheet position is exposed to interest rate decreases; use a short hedge. 
E) There is no interest rate risk exposure. 
A) The balance sheet position is exposed to interest rate increases; use a short hedge. 
B) The balance sheet position is exposed to interest rate increases; use a long hedge. 
C) The balance sheet position is exposed to interest rate decreases; use a long hedge. 
D) The balance sheet position is exposed to interest rate decreases; use a short hedge. 
E) There is no interest rate risk exposure.

Question 12

An investment company has purchased $100 million of 10 percent annual coupon, 6-year Eurobonds. The bonds have a duration of 4.79 years at the current market yields of 10 percent. The company wishes to hedge these bonds with Treasury-bond options that have a delta of 0.7. The duration of the underlying asset is 8.82, and the market value of the underlying asset is $98,000 per $100,000 face value. Finally, the volatility of the interest rates on the underlying bond of the options and the Eurobond is 0.84. Given this information, what type of T-bond option, and how many options should be purchased, to hedge this investment?

Accepted Answer

A) 792 put options. 
B) 792 call options. 
C) 942 put options. 
D) 942 call options. 
E) 554 put options. 
A) 792 put options. 
B) 792 call options. 
C) 942 put options. 
D) 942 call options. 
E) 554 put options.

Question 13

Giving the purchaser the right to sell the underlying security at a prespecified price is a

Accepted Answer

A) put option. 
B) call option. 
C) naked option. 
D) futures option. 
E) credit spread call option. 
A) put option. 
B) call option. 
C) naked option. 
D) futures option. 
E) credit spread call option.

Question 14

An investment company has purchased $100 million of 10 percent annual coupon, 6-year Eurobonds. The bonds have a duration of 4.79 years at the current market yields of 10 percent. The company wishes to hedge these bonds with Treasury-bond options that have a delta of 0.7. The duration of the underlying asset is 8.82, and the market value of the underlying asset is $98,000 per $100,000 face value. Finally, the volatility of the interest rates on the underlying bond of the options and the Eurobond is 0.84. What is the net gain or loss to the investment company resulting from the change in rates given that the hedge was placed?

Accepted Answer

A) Lose $2,131. 
B) Gain $2,131. 
C) Lose $695,191. 
D) Gain $695,191. 
E) Gain $2,382,858. 
A) Lose $2,131. 
B) Gain $2,131. 
C) Lose $695,191. 
D) Gain $695,191. 
E) Gain $2,382,858.

Question 15

The buyer of a bond put option stands to make a profit if changes in market interest rates cause the bond price to fall below the exercise price.

Accepted Answer

A) True 
 B)False

Question 16

Writing an interest rate call option may hedge an FI when rates rise and bond prices fall.

Accepted Answer

A) True 
 B)False

Question 17

A contract that pays the par value of a loan in the event of default is a

Accepted Answer

A) put option. 
B) call option. 
C) digital default option. 
D) futures option. 
E) credit spread call option. 
A) put option. 
B) call option. 
C) digital default option. 
D) futures option. 
E) credit spread call option.

Question 18

The total premium cost to an FI of hedging by buying put options is the price of each put option times the number of put options purchased.

Accepted Answer

A) True 
 B)False

Question 19

The loss to the buyer of a bond option is unlimited.

Accepted Answer

A) True 
 B)False

Question 20

Futures options on bonds have interest rate futures contracts as the underlying asset.

Accepted Answer

A) True 
 B)False

Exam 23: Options, Caps, Floors, and Collars

The outstanding number of put or call contracts is called

What reflects the degree to which the rate on the option's underlying asset moves relative to the spot rate on the asset or liability that is being hedged?

CBOT catastrophe call spread options have variable payoffs that are capped at a level of less than 100 percent of extreme losses.

An FI would normally purchase a cap if it was funding fixed-rate assets with variable-rate liabilities.

The concept of pull-to-maturity reflects the increasing variance of a bond's price as the maturity of the bond approaches.

For put options, the delta has a negative sign

Interest rate futures options are preferred to bond options because they have more favorable liquidity, credit risk, and market-to-market features.

Identify a problem associated with using the Black-Scholes model to value bond options.

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

A contract whose payoff increases as a yield spread increases above some stated exercise spread is a

Giving the purchaser the right to sell the underlying security at a prespecified price is a

The buyer of a bond put option stands to make a profit if changes in market interest rates cause the bond price to fall below the exercise price.

Writing an interest rate call option may hedge an FI when rates rise and bond prices fall.

A contract that pays the par value of a loan in the event of default is a

The total premium cost to an FI of hedging by buying put options is the price of each put option times the number of put options purchased.

The loss to the buyer of a bond option is unlimited.

Futures options on bonds have interest rate futures contracts as the underlying asset.

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