Question 1

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. C

Question 2

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?

Accepted Answer

A) 11.00 percent. 
B) 10.00 percent. 
C) 13.54 percent. 
D) 11.60 percent. 
E) 10.40 percent. 
A) 11.00 percent. 
B) 10.00 percent. 
C) 13.54 percent. 
D) 11.60 percent. 
E) 10.40 percent. B

Question 3

In April 2012, an FI bought a one-month sterling T-bill paying £100 million in May 2012. 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 £.
-If the exchange rate in one month is $1.55/£1, what action should the FI take in regards to the hedge?

Accepted Answer

A) Call the £100 million proceeds of the T-bill from the option writer for $160 million 
B) Put the £100 million proceeds from the T-bill to the option writer for $160 million. 
C) Put the £100 million proceeds from the T-bill to the option writer for $155 million. 
D) Call the £100 million proceeds of the T-bill from the option writer for $155 million 
E) Allow the option contracts to expire since they are out of the money. 
A) Call the £100 million proceeds of the T-bill from the option writer for $160 million 
B) Put the £100 million proceeds from the T-bill to the option writer for $160 million. 
C) Put the £100 million proceeds from the T-bill to the option writer for $155 million. 
D) Call the £100 million proceeds of the T-bill from the option writer for $155 million 
E) Allow the option contracts to expire since they are out of the money. B

Question 4

An option that does NOT identifiably hedge an underlying asset 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 5

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

Accepted Answer

A) True 
 B)False

Question 6

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

Accepted Answer

A) The options hedge has lower credit risk exposure. 
B) The options hedge has lower transaction costs. 
C) The options hedge is marked to market less frequently. 
D) The options hedge offers the most downside risk protection. 
E) The options hedge offers the most upside gain potential. 
A) The options hedge has lower credit risk exposure. 
B) The options hedge has lower transaction costs. 
C) The options hedge is marked to market less frequently. 
D) The options hedge offers the most downside risk protection. 
E) The options hedge offers the most upside gain potential.

Question 7

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

Accepted Answer

A) True 
 B)False

Question 8

Giving the purchaser the right to buy 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 9

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: $$\begin{array} { | l | c | c | c | c | } 
\hline \text { End of Year: } & 0 & 1 & 2 & 3 \
\hline \text { Cash Flow at end of year: } & - & - & \mathrm { x } & \mathrm { x } \
\hline
\end{array}$$
-Assume interest rates are 5 percent in year 2 and 7 percent in year 3. Which of the following is true?

Accepted Answer

A) The bank will receive $50,000 at the end of year 2 and receive $50,000 at the end of year 3. 
B) The bank will receive $50,000 at the end of year 2 and pay $50,000 at the end of year 3. 
C) The bank will receive $0 at the end of year 2 and pay $50,000 at the end of year 3. 
D) The bank will receive $0 at the end of year 2 and receive $50,000 at the end of year 3. 
E) The bank will receive $50,000 at the end of year 2 and pay $0 at the end of year 3. 
A) The bank will receive $50,000 at the end of year 2 and receive $50,000 at the end of year 3. 
B) The bank will receive $50,000 at the end of year 2 and pay $50,000 at the end of year 3. 
C) The bank will receive $0 at the end of year 2 and pay $50,000 at the end of year 3. 
D) The bank will receive $0 at the end of year 2 and receive $50,000 at the end of year 3. 
E) The bank will receive $50,000 at the end of year 2 and pay $0 at the end of year 3.

Question 10

Buying a cap option agreement

Accepted Answer

A) means buying a (or several) call option on interest rates. 
B) means buying insurance against excessive decreases in interest rates. 
C) allows more than one exercise date. 
D) All of the above are correct. 
E) Answers A and C only. 
A) means buying a (or several) call option on interest rates. 
B) means buying insurance against excessive decreases in interest rates. 
C) allows more than one exercise date. 
D) All of the above are correct. 
E) Answers A and C only.

Question 11

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.
-Using the above information and your answer to the previous question, will the investment company gain or lose on the option position if interest rates decrease 1 percent to 9 percent?

Accepted Answer

A) Lose $4,352,414. 
B) Gain $4,352,414. 
C) Lose $2,559,700. 
D) Gain $3,659,354. 
E) Lose $3,659,354. 
A) Lose $4,352,414. 
B) Gain $4,352,414. 
C) Lose $2,559,700. 
D) Gain $3,659,354. 
E) Lose $3,659,354.

Question 12

As interest rates increase, the writer of a bond call option stands to make

Accepted Answer

A) limited gains. 
B) limited losses. 
C) unlimited losses. 
D) unlimited gains. 
E) Answers A and B only. 
A) limited gains. 
B) limited losses. 
C) unlimited losses. 
D) unlimited gains. 
E) Answers A and B only.

Question 13

Which of the following observations is NOT true?

Accepted Answer

A) Variance of bond prices is nonconstant over time. 
B) Variance of bond prices rises at first and then falls as the bond approaches maturity. 
C) As the bond approaches maturity, all price paths must lead to 100 percent of the face value of the bond. 
D) As the bond approaches maturity, all price paths must lead to the principal paid by the issuer on maturity. 
E) Variance of a bond's price or return increases as maturity approaches. 
A) Variance of bond prices is nonconstant over time. 
B) Variance of bond prices rises at first and then falls as the bond approaches maturity. 
C) As the bond approaches maturity, all price paths must lead to 100 percent of the face value of the bond. 
D) As the bond approaches maturity, all price paths must lead to the principal paid by the issuer on maturity. 
E) Variance of a bond's price or return increases as maturity approaches.

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.
-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 15

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?

Accepted Answer

A) $912.40 and $922.32. 
B) $857.27 and $866.93. 
C) $734.90 and $751.56. 
D) $896.06 and $905.80. 
E) $802.92 and $820.47. 
A) $912.40 and $922.32. 
B) $857.27 and $866.93. 
C) $734.90 and $751.56. 
D) $896.06 and $905.80. 
E) $802.92 and $820.47.

Question 16

FIs may increase fee income by serving as a counterparty for other entities wanting to hedge risk on their own balance sheet.

Accepted Answer

A) True 
 B)False

Question 17

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

Accepted Answer

A) The futures hedge has lower credit risk exposure. 
B) The futures hedge reduces volatility in profit gains on both sides. 
C) The futures hedge is marked to market less frequently. 
D) The futures hedge offers the least downside risk protection. 
E) The futures hedge completely offsets losses but only partly offsets gains. 
A) The futures hedge has lower credit risk exposure. 
B) The futures hedge reduces volatility in profit gains on both sides. 
C) The futures hedge is marked to market less frequently. 
D) The futures hedge offers the least downside risk protection. 
E) The futures hedge completely offsets losses but only partly offsets gains.

Question 18

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 19

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

Accepted Answer

A) True 
 B)False

Question 20

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

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

An option that does NOT identifiably hedge an underlying asset is a

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

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

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

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

Buying a cap option agreement

As interest rates increase, the writer of a bond call option stands to make

Which of the following observations is NOT true?

FIs may increase fee income by serving as a counterparty for other entities wanting to hedge risk on their own balance sheet.

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

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

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

Why Are Financial Institutions Special

Financial Services: Depository Institutions

Financial Services: Finance Companies

Financial Services: Securities Brokerage and Investment Banking

Financial Services: Mutual Funds and Hedge Funds

Financial Services: Insurance

Risks of Financial Institutions

Interest Rate Risk I

Interest Rate Risk II

Credit Risk: Individual Loan Risk

Credit Risk: Loan Portfolio and Concentration Risk

Liquidity Risk

Foreign Exchange Risk

Sovereign Risk

Market Risk

Off-Balance-Sheet Risk

Technology and Other Operational Risks

Liability and Liquidity Management

Deposit Insurance and Other Liability Guarantees

Capital Adequacy

Product and Geographic Expansion

Futures and Forwards

Swaps

Loan Sales

Securitization

Filters

Exam 23: Options, Caps, Floors, and Collars

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

An option that does NOT identifiably hedge an underlying asset is a

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

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

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

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

Buying a cap option agreement

As interest rates increase, the writer of a bond call option stands to make

Which of the following observations is NOT true?

FIs may increase fee income by serving as a counterparty for other entities wanting to hedge risk on their own balance sheet.

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

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

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

Why Are Financial Institutions Special

Financial Services: Depository Institutions

Financial Services: Finance Companies

Financial Services: Securities Brokerage and Investment Banking

Financial Services: Mutual Funds and Hedge Funds

Financial Services: Insurance

Risks of Financial Institutions

Interest Rate Risk I

Interest Rate Risk II

Credit Risk: Individual Loan Risk

Credit Risk: Loan Portfolio and Concentration Risk

Liquidity Risk

Foreign Exchange Risk

Sovereign Risk

Market Risk

Off-Balance-Sheet Risk

Technology and Other Operational Risks

Liability and Liquidity Management

Deposit Insurance and Other Liability Guarantees

Capital Adequacy

Product and Geographic Expansion

Futures and Forwards

Swaps

Loan Sales

Securitization

Filters