Exam 23: Options, Caps, Floors, and Collars

The buyer of a bond call option stands to make a positive payoff if changes in market interest rates cause the bond price to rise above the exercise price.

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?

Credit spread call options are useful because

All else equal, the value of an option increases with an increase in the variance of returns in the underlying asset.

Buying a cap is similar to

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 5 percent floor if the current (spot) rates are also 6 percent? The face value is $5,000,000, and time periods are zero, one, and two.

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: - - -Instead of a cap, if the bank had purchased a 3-year 6 percent floor and interest rates are 5 percent and 6 percent in years 2 and 3, respectively, what are the payoffs to the bank?

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

Options become more valuable as the variability of interest rates decreases.

One advantage of caps, collars, and floors is that because they are exchange-traded options there is no counterparty risk present in the transactions.

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

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

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

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

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 exercise price of the option, what premium should be paid for this option?

A naked option is an option written that has no identifiable underlying asset or liability position.

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.

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: - - -In addition to purchasing the cap, if the bank also purchases a 3-year 6 percent floor and interest rates are 5 percent and 7 percent in years 2 and 3, respectively, what are the payoffs to the bank? Specifically, the bank will

The payoff of a credit spread call option increases as the yield spread on a specified benchmark bond increases above some exercise spread.