Question 1

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

Accepted Answer

A) True 
 B)False  True

Question 2

In April 2016,an FI bought a one-month sterling T-bill paying £100 million in May 2016.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 £.

What is the foreign exchange risk that the FI is facing,and what type of currency option should be purchased to hedge this risk?

Accepted Answer

A) The FI should use put options to hedge the depreciation of the dollar. 
B) The FI should use call options to hedge the depreciation of the pound sterling. 
C) The FI should use put options to hedge the depreciation of the pound sterling. 
D) The FI should use call options to hedge the depreciation of the dollar. 
A) The FI should use put options to hedge the depreciation of the dollar. 
B) The FI should use call options to hedge the depreciation of the pound sterling. 
C) The FI should use put options to hedge the depreciation of the pound sterling. 
D) The FI should use call options to hedge the depreciation of the dollar. C

Question 3

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

Accepted Answer

A) True 
 B)False  True

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

The buyer of a bond call option

Accepted Answer

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. 
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.

Question 6

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

Question 7

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 8

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

Question 9

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

Accepted Answer

A) True 
 B)False

Question 10

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?

Accepted Answer

A) $0.2143 per $100 of bond option purchased. 
B) $0.4420 per $100 of bond option purchased. 
C) $1.2768 per $100 of bond option purchased. 
D) $0.2321 per $100 of bond option purchased. 
A) $0.2143 per $100 of bond option purchased. 
B) $0.4420 per $100 of bond option purchased. 
C) $1.2768 per $100 of bond option purchased. 
D) $0.2321 per $100 of bond option purchased.

Question 11

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?

Accepted Answer

A) -$1,660,525. 
B) +$1,660,525. 
C) -$2,430,511. 
D) -$765,253. 
E) +$2,430,511. 
A) -$1,660,525. 
B) +$1,660,525. 
C) -$2,430,511. 
D) -$765,253. 
E) +$2,430,511.

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

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 15

The buyer of a bond put option

Accepted Answer

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. 
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.

Question 16

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

Accepted Answer

A) True 
 B)False

Question 17

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. 
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.

Question 18

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.

The duration of the T-notes,Baa bonds,and GICs is 1.93 years,6.9 years,and 4.5 years respectively.What is the leverage-adjusted duration gap for Allright?

Accepted Answer

A) 1.99 years. 
B) 5.13 years. 
C) 0.63 years. 
D) 1.91 years. 
A) 1.99 years. 
B) 5.13 years. 
C) 0.63 years. 
D) 1.91 years.

Question 19

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. 
A) put option. 
B) call option. 
C) naked option. 
D) futures option.

Question 20

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 cap 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) $25,000. 
B) $20,409. 
C) $22,041. 
D) $42,450. 
A) $25,000. 
B) $20,409. 
C) $22,041. 
D) $42,450.

Exam 23: Options, Caps, Floors, and Collars

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

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

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.

The buyer of a bond call option

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

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

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

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

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

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

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

The buyer of a bond put option

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

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?

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

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