Chapter 23 Options, Caps, Floors, and Collars (Better)

A digital default option

"Always pays the par value of a loan if exercised & will cause the FI never to lose more than the premium paid to purchase the option"

Buying a cap option agreement

"Means buying a (or several) call option on interest rates & allows more than one exercise date"

Credit spread call options are useful because

Answers A and B only.

Which of the following shows the change in the value of a put option for each $1 change in the underlying bond?

Delta.

Identify a problem associated with using the Black-Scholes model to value bond options

It assumes short-term interest rates are constant.

KKR issues a $10 million 18-month floating rate note priced at LIBOR plus 400 basis points. What is KKR's interest rate risk exposure and how can it be hedged?

KKR is exposed to interest rate increases; short hedge by buying put options.

What is the advantage of a futures hedge over an options hedge?

The futures hedge reduces volatility in profit gains on both sides.

What is the advantage of an options hedge over a futures hedge?

The options hedge offers the most upside gain potential.

Which of the following is a good strategy to adopt when interest rates are expected to rise?

Writing a call option on a bond.

Buying a cap is similar to

buying a call option on interest rates.

The combination of being long in the bond and buying a put option on a bond mimics the profit function of

buying a call option.

Giving the purchaser the right to buy the underlying security at a prespecified price is a

call option.

Rising interest rates will cause the market value of

call options on bonds to decrease.

Using the proceeds from the simultaneous sale of a floor to finance the purchase of a cap is to open a position called a

collar.

A contract whose payoff increases as a yield spread increases above some stated exercise spread is a

credit spread call option.

A contract that pays the par value of a loan in the event of default is a

digital default option.

The purchase often of a series of put options with multiple exercise dates results in a

floor.

A contract that results in the delivery of a futures contract when exercised is a

futures option.

As interest rates increase, the writer of a bond call option stands to make

limited gains.

An option that does NOT identifiably hedge an underlying asset is a

naked option.

The purchaser of an option must pay the writer a

premium.

The tendency of the variance of a bond's price to decrease as maturity approaches is called

pull-to-par.

An FI concerned that the risk on a loan will increase can

purchase a credit spread call option

Giving the purchaser the right to sell the underlying security at a prespecified price is a

put option.

For put options, the delta has a negative sign

since the value of the put option falls when bond prices rise.

What reflects the degree to which the rate on the option's underlying asset moves relative to the spot rate on the asset or liability that is being hedged?

Basis risk.

As interest rates increase, the buyer of a bond put option stands to

make limited gains.

The outstanding number of put or call contracts is called

open interest.

The buyer of a bond call option

pays a premium and has the right to buy the underlying bond at the agreed exercise price

The buyer of a bond put option

pays a premium and has the right to sell the underlying bond at the agreed exercise price.

The writer of a bond call option

receives a premium and must stand ready to sell the bond at the exercise price.

The writer of a bond put option

receives a premium in return for standing ready to buy bonds at the exercise price.

Contrast the marking to market characteristics of options versus futures contracts

Options are marked to market at expiration while futures are marked to market at the close of trading each day.

Purchasing a succession of call options on interest rates is called a

cap.

Which of the following holds true for the writer of a bond call option if interest rates decrease?

Potential to make large losses

Which of the following observations is NOT true?

Variance of a bond's price or return increases as maturity approaches.