Exam 23: Options, Caps, Floors, and Collars

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 and your answer to the previous question,will the investment company gain or lose on the option position if interest rates decrease 1 percent to 9 percent?

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

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?

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. At the time of placement,the premium on the options are quoted at 1¾.What is the cost to Allright in placing the hedge?

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: End of Year: 0 1 2 3 Cash Flow at end of year: - - x x In addition to purchasing the cap,if the bank also sells 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

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

A digital default option

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.

What is the advantage of a futures hedge over an options hedge?

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

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

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

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

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?

The writer of a bond call option

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.

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?

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

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

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.