Deck 24: Options, Caps, Floors, and Collars

Question 1

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

Answer 1

False

Question 2

Unlike futures and forward contracts, the use of options by FIs has deceased in recent years.

Answer 2

False

Question 3

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

Answer 3

True

Question 4

The most a call option buyer stands to lose is the amount of the call premium paid for the option.

Question 5

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

Question 6

Unlike futures contracts, options are traded electronically through an option dealer network known as the Options Clearing Corporation (OCC).

Question 7

Buying a call option on a bond ensures an FI that it will be able to sell the bond at a given point in time for a price at least equal to the exercise price of the option.

Question 8

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.

Question 9

The profit on bond call options moves asymmetrically with interest rates.

Question 10

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

Question 11

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

Question 12

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

Question 13

The Chicago Board Options Exchange (CBOE) was the first exchange devoted solely to the trading of options.

Question 14

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 by enough to recoup the option premium paid.

Question 15

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.

Question 16

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

Question 17

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

Question 18

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

Question 19

The payoffs on bond call options move symmetrically with changes in interest rates.

Question 20

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 by enough to recoup the call premium paid for the option.

Question 21

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

Question 22

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

Question 23

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

Question 24

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

Question 25

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

Question 26

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.

Question 27

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.

Question 28

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.

Question 29

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

Question 30

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

Question 31

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

Question 32

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

Question 33

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

Question 34

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

Question 35

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

Question 36

A hedge using a put option contract completely offsets gains but only but only partially offsets losses on an FIs balance sheet.

Question 37

The preferred method of FIs when hedging interest rates is an option on interest rate futures rather than using a pure bond option.

Question 38

Most pure bond options trade on the over the counter markets as opposed to organized exchanges such as the Chicago Board Options Exchange.

Question 39

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

Question 40

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

Question 41

A call option on the loss ratio incurred in writing catastrophe insurance with a capped payout is referred to as a maximum call spread.

Question 42

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

Question 43

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

Question 44

A hedge of interest rate risk with a put option on futures completely offsets gains but only partly offsets losses.

Question 45

There are regulatory reasons why FIs buy options rather than write options.For example viewing naked options as risky because of the large loss potential.

Question 46

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

Question 47

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

Question 48

A hedge with futures contracts increases volatility in profit gains on both the upside and downside of interest rate movements, whereas in comparison, the hedge with the put option contract completely offsets the gains but only partially offsets the losses.

Question 49

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

Question 50

A digital default option expires unexercised in situations where the loan is paid in accordance with the loan agreement.

Question 51

Buying a cap is like buying insurance against a decrease in interest rates.

Question 52

As of 2015, commercial banks had listed for sale option contracts with a notational value of approximately

A)$16.2 trillion.
B)$31.9 trillion.
C)$8.1 trillion.
D)$51.0 trillion.
E)$36.9 trillion.

Question 53

Buying a put option truncated the downside losses on the bond following interest rate rises to some maximum amount and scales down the upside profits by the cost of bond price risk insurance, leaving some positive upside profit potential.

Question 54

The premium on a credit spread call option is the maximum potential loss to the buyer of the option when the credit spread increases.

Question 55

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

Question 56

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

Question 57

The Chicago Board of Trade (CBOT) catastrophe call spread options have variable payoffs that are capped at a level of less than 100 percent of extreme losses.

Question 58

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.

Question 59

A digital default option pays a stated amount in the event that a portion of the loan is not paid.

Question 60

The purchaser of an option must pay the writer a

A)strike price.
B)market price.
C)margin.
D)premium.
E)basis.

Question 61

The writer of a bond put option

A)receives a premium in return for standing ready to sell the bond at the exercise price.
B)receives a premium in return for standing ready to buy bonds at the exercise price.
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price.
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 62

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

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

Question 63

As interest rates increase, the buyer of a bond put option stands to

A)make limited gains.
B)incur limited losses.
C)incur unlimited losses.
D)lose the entire premium amount.
E)make limited gains and lose the entire premium amount.

Question 64

A contract that results in the delivery of a futures contract when exercised is a

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

Question 65

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

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

Question 66

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

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

Question 67

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

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

Question 68

The writer of a bond call option

A)receives a premium and must stand ready to sell the bond at the exercise price.
B)receives a premium and must stand ready to buy bonds at the exercise price.
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price.
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price.
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price.

Question 69

Which of the following holds true for the writer of a bond call option if interest rates decrease?

A)Makes profits limited to call premium
B)Makes losses limited to call premium
C)Potential to make large losses
D)Potential to make unlimited profits
E)Makes losses limited to call premium and potential to make unlimited profits

Question 70

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

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

Question 71

The buyer of a bond call option

A)receives a premium in return for standing ready to sell the bond at the exercise price.
B)receives a premium in return for standing ready to buy bonds at the exercise price.
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price.
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 72

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

A)open interest.
B)pull-to-par.
C)digital default option.
D)futures option.
E)credit spread call option.

Question 73

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

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

Question 74

Which of the following observations is NOT true?

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 75

The outstanding number of put or call contracts is called

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

Question 76

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

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

Question 77

The buyer of a bond put option

A)receives a premium in return for standing ready to sell the bond at the exercise price.
B)receives a premium in return for standing ready to buy bonds at the exercise price.
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price.
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 78

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

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

Question 79

Buying a cap is similar to

A)writing a call option on interest rates.
B)buying a call option on interest rates.
C)buying a put option on interest rates.
D)buying a floor on interest rates.
E)buying a collar on interest rates.

Question 80

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

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