Deck 23: Options, Caps, Floors, and Collars

Question 1

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.

Answer 1

True

Question 2

A naked option is an option written that has no identifiable underlying asset or liability position.

Answer 2

True

Question 3

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

Answer 3

False

Question 4

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

Question 5

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.

Question 6

The loss to the buyer of a bond option is unlimited.

Question 7

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

Question 8

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

Question 9

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

Question 10

The losses on a purchased put option position when rates fall are limited to the option premium paid.

Question 11

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

Question 12

When interest rates rise, writing a bond call option may cause profits to offset the loss on an FI's bonds.

Question 13

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

Question 14

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.

Question 15

The loss to a buyer of bond put options is limited to the premium paid.

Question 16

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

Question 17

Buying a call option on a bond ensures a bank 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.

Question 18

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

Question 19

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

Question 20

The gain to the writer of a bond option is unlimited.

Question 21

CBOT catastrophe call spread options have variable payoffs that are capped at a level of less than 100 percent of extreme losses.

Question 22

A hedge with a futures contract reduces volatility in payoff gains on both the upside and downside of interest rate movements.

Question 23

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

Question 24

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

Question 25

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

Question 26

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

Question 27

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

Question 28

A hedge of interest rate risk with a put option completely offsets gains but only partly offsets losses.

Question 29

Open interest refers to the dollar amount of outstanding option contracts.

Question 30

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

Question 31

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

Question 32

Futures options on bonds have interest rate futures contracts as the underlying asset.

Question 33

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.

Question 34

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

Question 35

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.

Question 36

The premium on a credit spread call option is the maximum loss attainable to the buyer of the option in situations where the credit spread increases.

Question 37

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.

Question 38

A digital default option pays a stated amount in the event that a portion of the loan is not paid.

Question 39

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

Question 40

The payoff of a credit spread call option increases as the yield spread on a specified benchmark bond increases above some exercise spread.

Question 41

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

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

Question 42

An FI buys a collar by buying a floor and selling a cap.

Question 43

A contract that pays the par value of a loan in the event of default is a

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

Question 44

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

Question 45

The buyer of a bond put option

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
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 46

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

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

Question 47

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

Question 48

The buyer of a bond call option

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
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 49

The tendency of the variance of a bond's price to decrease as maturity approaches is called

A)open interest.
B)pull-to-par.
C)digital default option.
D)futures option.
E)credit spread call option.

Question 50

As of June 2012, commercial banks had listed for sale option contracts with a notational value of approximately

A)$16.2 trillion.
B)$33.6 trillion.
C)$8.1 trillion.
D)$51.0 trillion.
E)$36.9 trillion.

Question 51

The writer of a bond call option

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 52

The writer of a bond put option

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
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price

Question 53

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

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

Question 54

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.

Question 55

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

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

Question 56

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

Question 57

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

Question 58

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

Question 59

A contract that results in the delivery of a futures contract when exercised is a

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

Question 60

The purchaser of an option must pay the writer a

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

Question 61

Which of the following observations is NOT true?

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 62

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

A)The futures hedge has lower credit risk exposure.
B)The futures hedge reduces volatility in profit gains on both sides.
C)The futures hedge is marked to market less frequently.
D)The futures hedge offers the least downside risk protection.
E)The futures hedge completely offsets losses but only partly offsets gains.

Question 63

The outstanding number of put or call contracts is called

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

Question 64

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

A)The options hedge has lower credit risk exposure.
B)The options hedge has lower transaction costs.
C)The options hedge is marked to market less frequently.
D)The options hedge offers the most downside risk protection.
E)The options hedge offers the most upside gain potential.

Question 65

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

A)limited gains.
B)limited losses.
C)unlimited losses.
D)unlimited gains.
E)Answers A and B only.

Question 66

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

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.
E)All of the above.

Question 67

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?

A)Credit risk.
B)Basis risk.
C)Hedge risk.
D)Volatility.
E)Open interest.

Question 68

For put options, the delta has a negative sign

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.
E)to adjust for basis risk.

Question 69

The purchase often of a series of put options with multiple exercise dates results in a

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

Question 70

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?

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 71

Buying a cap is similar to

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 72

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

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 the above.

Question 73

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

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

Question 74

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

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
E)Answers B and D only.

Question 75

The combination of being long in the bond and buying a put option on a bond mimics the profit function of

A)buying a put option.
B)writing a put option.
C)writing a call option.
D)buying a call option.
E)buying a floor.

Question 76

Which of the following shows the change in the value of a put option for each $1 change in the underlying bond?

A)Open interest.
B)Volatility.
C)Delta.
D)Basis.
E)Sigma.

Question 77

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

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

Question 78

Rising interest rates will cause the market value of

A)call options on bonds to increase.
B)put options on bonds to decrease.
C)call options on bonds to decrease.
D)bond futures to increase.
E)Answers A and B only.

Question 79

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

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

Question 80

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

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.