Question 1

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

Accepted Answer

A) True 
 B)False

Question 2

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

Accepted Answer

A) True 
 B)False

Question 3

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?

Accepted Answer

A) KKR is exposed to interest rate increases; short hedge by buying put options. 
B) KKR is exposed to interest rate increases; long hedge by buying call options. 
C) KKR is exposed to interest rate decreases; long hedge by buying call options. 
D) KKR is exposed to interest rate decreases; short hedge by buying put options. 
E) KKR is exposed to interest rate increases; short hedge by buying call options. 
A) KKR is exposed to interest rate increases; short hedge by buying put options. 
B) KKR is exposed to interest rate increases; long hedge by buying call options. 
C) KKR is exposed to interest rate decreases; long hedge by buying call options. 
D) KKR is exposed to interest rate decreases; short hedge by buying put options. 
E) KKR is exposed to interest rate increases; short hedge by buying call options.

Question 4

Contrast the marking to market characteristics of options versus futures contracts.

Accepted Answer

A) Options are marked to market continuously while futures are marked to market at the close of trading each day. 
B) Options are marked to market at expiration while futures are marked to market at the close of trading each day. 
C) Options are marked to market daily while futures are marked to market at the close of trading each day. 
D) Options are marked to market monthly while futures are marked to market at the close of trading each day. 
E) There is no difference in the marking to market characteristics. 
A) Options are marked to market continuously while futures are marked to market at the close of trading each day. 
B) Options are marked to market at expiration while futures are marked to market at the close of trading each day. 
C) Options are marked to market daily while futures are marked to market at the close of trading each day. 
D) Options are marked to market monthly while futures are marked to market at the close of trading each day. 
E) There is no difference in the marking to market characteristics.

Question 5

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:   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

Accepted Answer

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

Question 6

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

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 7

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

Accepted Answer

A) Buying a call option on a bond. 
B) Writing a call option on a bond. 
C) Writing a put option on a bond. 
D) Buying bond futures. 
E) All of these. 
A) Buying a call option on a bond. 
B) Writing a call option on a bond. 
C) Writing a put option on a bond. 
D) Buying bond futures. 
E) All of these.

Question 8

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

Accepted Answer

A) True 
 B)False

Question 9

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 net price of a $5,000,000 collar if the bank purchases a three-year 6 percent cap and sells a 5 percent floor, if the current (spot) rates are 6 percent?

Accepted Answer

A) The bank will receive net $2,010. 
B) The bank will receive net $31,651. 
C) The bank will pay net $31,651. 
D) The bank will pay net $2,010. 
E) price = $0 
A) The bank will receive net $2,010. 
B) The bank will receive net $31,651. 
C) The bank will pay net $31,651. 
D) The bank will pay net $2,010. 
E) price = $0

Question 10

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

Accepted Answer

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 account. 
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 account.

Question 11

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

Accepted Answer

A) True 
 B)False

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

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 6 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.

Accepted Answer

A) $44,060. 
B) $66,030. 
C) $22,462. 
D) $21,598. 
E) $25,000. 
A) $44,060. 
B) $66,030. 
C) $22,462. 
D) $21,598. 
E) $25,000.

Question 14

A digital default option

Accepted Answer

A) always pays the par value of a loan if exercised. 
B) has a payout that is capped at 80 percent of the par value of the loan. 
C) will cause the FI never to lose more than the premium paid to purchase the option. 
D) always pays the par value of a loan if exercised, and will cause the FI never to lose more than the premium paid to purchase the option. 
E) always pays the par value of a loan if exercised, and has a payout that is capped at 80 percent of the par value of the loan. 
A) always pays the par value of a loan if exercised. 
B) has a payout that is capped at 80 percent of the par value of the loan. 
C) will cause the FI never to lose more than the premium paid to purchase the option. 
D) always pays the par value of a loan if exercised, and will cause the FI never to lose more than the premium paid to purchase the option. 
E) always pays the par value of a loan if exercised, and has a payout that is capped at 80 percent of the par value of the loan.

Question 15

Buying a cap is similar to

Accepted Answer

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. 
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 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

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 these are correct. 
E) means buying a (or several) call option on interest rates, and allows more than one exercise date. 
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 these are correct. 
E) means buying a (or several) call option on interest rates, and allows more than one exercise date.

Question 18

The writer of a bond call option

Accepted Answer

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. 
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 19

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.

Accepted Answer

A) $8,250. 
B) $10,799. 
C) $12,550. 
D) $15,875. 
E) $17,455. 
A) $8,250. 
B) $10,799. 
C) $12,550. 
D) $15,875. 
E) $17,455.

Question 20

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.

Exam 23: Options, Caps, Floors, and Collars

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

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

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?

Contrast the marking to market characteristics of options versus futures contracts.

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

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

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

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

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

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

A digital default option

Buying a cap is similar to

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

Buying a cap option agreement

The writer of a bond call option

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