Exam 23: Options, Caps, Floors, and Collars

Hedging the FI's interest rate risk by buying a put option on a bond is an attractive alternative to a manager.

The trading process of options is the same as that of futures contracts.

The purchase often of a series of put options with multiple exercise dates results in a

The buyer of a bond put option

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 rates increase 1 percent, what will be the change in value of the option position?

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

Purchasing a succession of call options on interest rates is called a

Regulators tend to discourage, and even prohibit in some cases, FIs from writing options because the upside potential is unlimited and the downside losses are potentially limited.

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. -What is the yield to maturity for the two-year bond if held to maturity?

Exercise of a put option on interest rate futures by the buyer of the option results in the buyer putting to the writer the bond futures contract at an exercise price higher than the currently trading bond future.

The purchaser of an option must pay the writer a

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, what will happen to the market value of the Eurobonds if market interest rates fall 1 percent to 9 percent?

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?

Using the proceeds from the simultaneous sale of a floor to finance the purchase of a cap is to open a position called a

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?

Managing interest rate risk for less creditworthy FI's by running a cap/floor book may require the backing of external guarantees such as standby letters of credit because of the nature of the options.

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

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?

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

The Black-Scholes model does not work well to value bond options because of violations of the underlying assumption of a constant variance of returns on the underlying asset.