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?

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:

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

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

Quizplus · Accepted Answer

The cap pays when the interest rate exceeds the cap rate. In year 2, the rate is 5%, below the 6% cap, so no payment is made. In year 3, the rate is 7%, above the cap, so the bank receives $50,000.