Question 1

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

Accepted Answer

A) True 
 B)False

Question 2

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?

Accepted Answer

A) The balance sheet position is exposed to interest rate increases;use a short hedge. 
B) The balance sheet position is exposed to interest rate increases;use a long hedge. 
C) The balance sheet position is exposed to interest rate decreases;use a long hedge. 
D) The balance sheet position is exposed to interest rate decreases;use a short hedge. 
A) The balance sheet position is exposed to interest rate increases;use a short hedge. 
B) The balance sheet position is exposed to interest rate increases;use a long hedge. 
C) The balance sheet position is exposed to interest rate decreases;use a long hedge. 
D) The balance sheet position is exposed to interest rate decreases;use a short hedge.

Question 3

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?

Accepted Answer

A) 27.99 percent. 
B) 13.54 percent. 
C) 29.95 percent. 
D) 14.00 percent. 
A) 27.99 percent. 
B) 13.54 percent. 
C) 29.95 percent. 
D) 14.00 percent.

Question 4

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

Question 5

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

Accepted Answer

A) True 
 B)False

Question 6

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

Accepted Answer

A) True 
 B)False

Question 7

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

Accepted Answer

A) True 
 B)False

Question 8

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

Question 9

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

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A) True 
 B)False

Question 11

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

Accepted Answer

A) True 
 B)False

Question 12

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

Accepted Answer

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 
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

Question 13

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.

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

Accepted Answer

A) 11.00 percent. 
B) 10.00 percent. 
C) 13.54 percent. 
D) 11.60 percent. 
A) 11.00 percent. 
B) 10.00 percent. 
C) 13.54 percent. 
D) 11.60 percent.

Question 14

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.

Accepted Answer

A) True 
 B)False

Question 15

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:

$\begin{array}{lllll}
\text { End of Year: } & 0 & 1 & 2 & 3 \
\text { Cash Flow at end of year:  }&- & - & x & x \
\hline
\end{array}$

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. 
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.

Question 16

For put options,the delta has a negative sign

Accepted Answer

A) since the value of the put option falls when bond prices rise. 
B) since the value of the put option rises when bond prices rise. 
C) since the value of the put option falls when bond prices fall. 
D) since the change in interest rates is equal to the change in the interest rate on the bond underlying the option contract. 
A) since the value of the put option falls when bond prices rise. 
B) since the value of the put option rises when bond prices rise. 
C) since the value of the put option falls when bond prices fall. 
D) since the change in interest rates is equal to the change in the interest rate on the bond underlying the option contract.

Question 17

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

Accepted Answer

A) True 
 B)False

Question 18

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

Accepted Answer

A) True 
 B)False

Question 19

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

Accepted Answer

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

Question 20

Credit spread call options are useful because

Accepted Answer

A) its value increases as the risk premium on a specified benchmark bond of the borrower increases above some exercise spread. 
B) an increase in the value of the call option will tend to offset the decreasing value of an FI's loan and net worth as the credit quality of the borrower decreases. 
C) they will always cause a loss at least equal to the required premium on the option. 
D) All of the options. 
E) its value increases as the risk premium on a specified benchmark bond of the borrower increases above some exercise spread and an increase in the value of the call option will tend to offset the decreasing value of an FI's loan and net worth as the credit quality of the borrower decreases. 
A) its value increases as the risk premium on a specified benchmark bond of the borrower increases above some exercise spread. 
B) an increase in the value of the call option will tend to offset the decreasing value of an FI's loan and net worth as the credit quality of the borrower decreases. 
C) they will always cause a loss at least equal to the required premium on the option. 
D) All of the options. 
E) its value increases as the risk premium on a specified benchmark bond of the borrower increases above some exercise spread and an increase in the value of the call option will tend to offset the decreasing value of an FI's loan and net worth as the credit quality of the borrower decreases.

Exam 23: Options, Caps, Floors, and Collars

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

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

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

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

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

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

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

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

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

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.

For put options,the delta has a negative sign

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

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

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

Credit spread call options are useful because

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