Question 1

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 2

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.

Given the expected one-year rates in one year,what are the possible bond prices in one year?

Accepted Answer

A) $912.40 and $922.32. 
B) $857.27 and $866.93. 
C) $734.90 and $751.56. 
D) $896.06 and $905.80. 
A) $912.40 and $922.32. 
B) $857.27 and $866.93. 
C) $734.90 and $751.56. 
D) $896.06 and $905.80.

Question 3

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

Accepted Answer

A) True 
 B)False

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

Using the proceeds from the simultaneous sale of a floor to finance the purchase of a cap is to open a position 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 6

Identify a problem associated with using the Black-Scholes model to value bond options.

Accepted Answer

A) It assumes short-term interest rates are constant. 
B) It assumes that commissions are charged. 
C) It assumes fluctuating variance of returns on the underlying asset. 
D) It assumes that the variance of bond prices is constant over time. 
A) It assumes short-term interest rates are constant. 
B) It assumes that commissions are charged. 
C) It assumes fluctuating variance of returns on the underlying asset. 
D) It assumes that the variance of bond prices is constant over time.

Question 7

An FI concerned that the risk on a loan will increase can

Accepted Answer

A) purchase a credit spread call option. 
B) sell a credit spread call option. 
C) sell a credit spread put option. 
D) purchase a naked option. 
A) purchase a credit spread call option. 
B) sell a credit spread call option. 
C) sell a credit spread put option. 
D) purchase a naked option.

Question 8

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

Accepted Answer

A) True 
 B)False

Question 9

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.

Accepted Answer

A) True 
 B)False

Question 10

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.

Accepted Answer

A) True 
 B)False

Question 11

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.

What is the net gain or loss to the investment company resulting from the change in rates given that the hedge was placed?

Accepted Answer

A) Lose $2,131. 
B) Gain $2,131. 
C) Lose $695,191. 
D) Gain $695,191. 
A) Lose $2,131. 
B) Gain $2,131. 
C) Lose $695,191. 
D) Gain $695,191.

Question 12

The purchaser of an option must pay the writer a

Accepted Answer

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

Question 13

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.

On the advice of its chief financial officer,Allright wants to hedge the balance sheet with T-bond option contracts.The underlying bonds currently have a duration of 8.82 years and a market value of $97,000 per $100,000 face value.Further,the delta of the options is 0.5.What type of contract,and how many contracts should Allright use to hedge this balance sheet?

Accepted Answer

A) puts;447 contracts. 
B) calls;625 contracts. 
C) puts;625 contracts. 
D) calls;447 contracts. 
A) puts;447 contracts. 
B) calls;625 contracts. 
C) puts;625 contracts. 
D) calls;447 contracts.

Question 14

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

Question 15

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

Question 16

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.

Accepted Answer

A) True 
 B)False

Question 17

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:

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

Assume interest rates are 5 percent in year 2 and 7 percent in year 3.Which of the following is true?

Accepted Answer

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

Question 18

Which of the following observations is NOT true?

Accepted Answer

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. 
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 19

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.

Accepted Answer

A) True 
 B)False

Question 20

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.

Accepted Answer

A) True 
 B)False

Exam 23: Options, Caps, Floors, and Collars

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

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

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.

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

Identify a problem associated with using the Black-Scholes model to value bond options.

An FI concerned that the risk on a loan will increase can

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

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.

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.

The purchaser of an option must pay the writer a

Buying a cap option agreement

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.

Which of the following observations is NOT true?

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.

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.

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