Question 1

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

Accepted Answer

CBOT catastrophe call spread options are designed to provide payouts based on specific loss indices, with payoffs capped to limit the maximum payout to less than the total extreme losses.

Question 2

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

Accepted Answer

A hedge with a futures contract can protect against losses in the event of adverse interest rate movements, while also limiting gains if interest rates move favorably. This helps to reduce volatility in payoff gains on both the upside and downside.

Question 3

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 hedge using a put option contract is designed to protect against losses by giving the right to sell at a predetermined price, but it does not offset gains because the holder can still benefit from favorable movements in the underlying asset's price.

Question 4

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

Accepted Answer

Most bond options are traded over the counter, meaning they are not traded on organized exchanges like the Chicago Board Options Exchange.

Question 5

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

Accepted Answer

Options become more valuable as the variability of interest rates increases, because higher volatility increases the potential for profit from the option's leverage.

Question 6

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

Accepted Answer

The concept of pull-to-maturity (or pull-to-par) actually refers to the phenomenon where the price of a bond tends to move towards its par value as the maturity date approaches, assuming no change in credit quality or interest rates. This is because at maturity, the bond will be redeemed at its par value.

Question 7

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

Accepted Answer

An option's delta has a value between -1 and 1 for puts, and 0 and 1 for calls, not 0 and 100.

Question 8

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

Accepted Answer

A put option can protect against losses due to a rise in interest rates, but it comes at a cost (the premium paid for the option). If interest rates do not rise, the investor would not need the insurance and would have to accept the cost of the option. Therefore, gains are not completely offset, only losses are partially offset.

Question 9

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

Accepted Answer

Open interest refers to the total number of outstanding option contracts, not the dollar amount.

Question 10

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

Accepted Answer

A digital default option is an agreement where the lender agrees to waive or reduce certain fees or interest rates if the borrower meets certain conditions or pays the loan on time. If the loan is paid in accordance with the loan agreement, the digital default option will expire unexercised.

Question 11

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

Accepted Answer

Interest rate futures options are more actively traded and have a more transparent price discovery process which results in better liquidity. They also have lower credit risk as they are traded on a centralized exchange and are typically settled through a clearinghouse. Additionally, interest rate futures options are marked-to-market daily, which reduces counterparty risk and provides greater transparency in terms of price movement. In contrast, bond options are traded over-the-counter and have less standardized terms which can limit liquidity and increase credit risk.

Question 12

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

Accepted Answer

Futures options on bonds typically have interest rate futures contracts as the underlying asset. This is because bond prices are highly sensitive to changes in interest rates, and interest rate futures provide a way to hedge or speculate on changes in interest rates.

Question 13

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.

Accepted Answer

In a put option on interest rate futures, the buyer has the right, but not the obligation, to sell the underlying bond futures contract at a predetermined price (exercise price). If the market price of the bond futures is lower than the exercise price, exercising the option allows the buyer to sell the bond futures at a higher price than the current market price, which is beneficial for the buyer.

Question 14

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

Accepted Answer

This is because higher variance increases the likelihood of the underlying asset experiencing a large price movement, which can result in greater potential gains for the option holder.

Question 15

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

The Black-Scholes model assumes that returns on the underlying asset have a constant variance, which is not true for bonds. Therefore, the model may not provide accurate valuations for bond options.

Question 16

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.

Accepted Answer

The premium is the cost of purchasing the option, not the maximum loss. The maximum loss for the buyer is the premium paid if the option expires worthless.

Question 17

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

This statement is true. The total premium cost of hedging is calculated by multiplying the price of each put option by the number of put options purchased.

Question 18

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

Accepted Answer

A digital default option is a type of financial agreement where a lender pays a predetermined amount to an investor or insurer in the event that a borrower defaults on a loan.

Question 19

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

Accepted Answer

When interest rates increase, the cost of carrying the futures contract increases. As a result, the holder of a put option on futures may choose to exercise the option to sell the underlying futures contract at a higher strike price and avoid incurring additional carrying costs.

Question 20

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

Accepted Answer

A credit spread call option involves selling a call option with a higher strike price and buying a call option with a lower strike price on the same underlying security. The profit from this strategy comes from the difference between the premiums received and paid for the two options. As the yield spread on a benchmark bond (such as Treasury bonds) increases above the exercise spread (the difference between the strike prices), the value of the credit spread call option increases, resulting in a higher payoff. Therefore, the statement is true.

Quiz 23: Options, Caps, Floors, and Collars