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 cap provides the bank with payment if the interest rate exceeds the cap rate. Therefore, the bank will receive payment only if the interest rate exceeds 6 percent.
At the end of the year 2, interest rate is 5 percent, which is below the cap rate of 6 percent. Therefore, the bank will not receive any payment at the end of year 2.
At the end of the year 3, interest rate is 7 percent, which is above the cap rate of 6 percent. Therefore, the bank will receive payment of $50,000 at the end of year 3.
Thus, the correct choice is D i.e. The bank will receive $0 at the end of year 2 and receive $50,000 at the end of year 3.

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