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: $$\begin{array} { | l | c | c | c | c | }
\hline \text { End of Year: } & 0 & 1 & 2 & 3 \
\hline \text { Cash Flow at end of year: } & - & - & \mathrm { x } & \mathrm { x } \
\hline
\end{array}$$
-In addition to purchasing the cap, if the bank also sells a 3-year 6 percent floor and interest rates are 5 percent and 7 percent in years 2 and 3, respectively, what are the payoffs to the bank? Specifically, the bank

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: $$\begin{array} { | l | c | c | c | c | } 
\hline \text { End of Year: } & 0 & 1 & 2 & 3 \
\hline \text { Cash Flow at end of year: } & - & - & \mathrm { x } & \mathrm { x } \
\hline
\end{array}$$
-In addition to purchasing the cap, if the bank also sells a 3-year 6 percent floor and interest rates are 5 percent and 7 percent in years 2 and 3, respectively, what are the payoffs to the bank? Specifically, the bank

Quizplus · Accepted Answer

The purchased cap provides payments at the end of year 2 and year 3, which means that the bank has protection against interest rates rising above 6%. If interest rates rise to 7%, the bank will receive a payment of $50,000 at the end of year 2 and a payment of $50,000 at the end of year 3.

The sold floor provides payments at the end of year 2 and year 3 if interest rates fall below 6%. If interest rates fall to 5%, the bank will have to make a payment of $50,000 at the end of year 2. However, because interest rates rose to 7% at the end of year 3, the bank will receive a payment of $50,000 at the end of year 3.

Therefore, the net payoff to the bank is to pay $50,000 at the end of year 2 and receive $50,000 at the end of year 3, which is answer choice B.

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