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: $$\begin{array} { | l | c | c | c | c | }
\hline \text { End of Year: } & 0 & 1 & 2 & 3 \
\hline \text { Cash Flow at end of year: } & - & - & \mathrm { x } & \mathrm { x } \
\hline
\end{array}$$ Assume interest rates are 5 percent in year 2 and 7 percent in year 3.Which of the following is true?

Question

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: $$\begin{array} { | l | c | c | c | c | } 
\hline \text { End of Year: } & 0 & 1 & 2 & 3 \
\hline \text { Cash Flow at end of year: } & - & - & \mathrm { x } & \mathrm { x } \
\hline
\end{array}$$ Assume interest rates are 5 percent in year 2 and 7 percent in year 3.Which of the following is true?

Quizplus · Accepted Answer

The bank will receive $0 at the end of year 2 because the interest rate (5%) is below the cap rate (6%). At the end of year 3, the bank will receive $50,000 because the interest rate (7%) exceeds the cap rate, and the payment is calculated based on the difference between the actual interest rate and the cap rate on the principal amount.

A Bank Purchases a 3-Year, 6 Percent $5 Million Cap