Gypsy

The owner, of an interest-rate cap will:

A) receive a payment if the market rate exceeds the cap rate.

B) be required to make a payment if the market rate exceeds the cap rate.

C) receive a payment if the market rate is less than the cap rate.

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An interest-rate cap will pay its owner the maximum of zero or the market rate minus the cap rate, times the notional principal.

Gypsy

Buying an interest-rate cap and selling an interest-rate floor is equivalent to:

A) buying a series of interest-rate puts and selling a series of interest rate calls.

B) buying a series of interest-rate calls and selling a series of interest-rate puts.

C) buying a series of interest-rate puts and calls.

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A cap is equivalent to a series of (long) interest-rate calls and selling a floor is equivalent to selling a series of interest-rate puts.

Gypsy

An investor who bought a floating-rate security and wishes to establish a minimum periodic cash flow on his investment could:

A) sell an interest-rate floor.

B) buy an interest-rate floor.

C) sell an interest-rate cap.

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The buyer of a floor will receive a payment when the floating rate is below the floor rate, effectively establishing a minimum rate on the floating rate security.

Gypsy

The value of an interest-rate call option at expiration is zero or the:

A) present value of, the market rate minus the exercise rate, adjusted for the period of the rate, times the principal amount.

B) market rate minus the exercise rate, adjusted for the period of the rate, times the principal amount.

C) exercise rate minus the market rate, adjusted for the period of the rate, times the principal amount.

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An interest rate call pays zero or the market rate at expiration minus the exercise rate. Since the payment is made at a date after expiration by the period of the reference rate, the value at expiration is the present value of this difference times the principal value.

Gypsy

Which of the following descriptions of how option payoffs are determined is most accurate?

A) The long position in an interest rate call option receives cash at expiration equal to Max[0, (reference rate-strike rate)] x notional principal amount.

B) Payoffs on futures options can be determined without knowing the spot price of the underlying commodity.

C) An equity call option holder receives cash in the amount by which the exercise price is greater than the strike price.

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When the holder exercises a futures option, he receives an underlying futures position. The cash payoff is the value the holder gains when that position is marked to market. Thus, the payoff is the difference between the exercise price and the futures contract price. Although it certainly influences the futures price, the spot price of the underlying commodity does not enter into the calculation of the payoff on the option.
The long position in an interest rate call option receives cash if the reference rate is greater than the strike rate, but does not receive it at expiration. The term of the reference rate (for example, 90-day LIBOR) determines the length of time after expiration when the cash changes hands. Options that pay at expiration pay the present value of the amount described. Determining the payoff on a stock index option requires the index level, the exercise price, and the contract multiplier. The strike price is another name for the exercise price.

Gypsy

The payoff of a call option on a stock at expiration is equal to:

A) the minimum of zero and the stock price minus the exercise price.

B) the maximum of zero and the stock price minus the exercise price.

C) the maximum of zero and the exercise price minus the stock price.

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The payoff on a call option on a stock is Max (0, S – X).

Gypsy

When calculating the payoff for a stock option, if the stock price is greater than the strike price at expiration:

A) a call option expires worthless.

B) the payoff to a put option is equal to the strike price.

C) the payoff to a call option is the difference between the stock price and the strike price.

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If the stock price is greater than the strike price at expiration, the payoff to a call option on the stock equals the stock price minus the strike price, while a put option on the stock expires worthless.

Gypsy

Consider a long position in a LIBOR-based interest rate call option with a notional amount of $1,000,000 and a strike rate of 4%. If at expiration LIBOR is less than 4%, the call option buyer receives:

A) $0.

B) $1,000,000 × (4% – LIBOR).

C) $1,000,000 × (LIBOR – 4%).

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If LIBOR at expiration is less than the strike rate, the interest rate call option expires worthless.

Gypsy

An important difference between interest rate options and bond options is that:

A) bond options must account for coupon payments.

B) bond options have positive payoffs when rates increase, interest-rate options when rates decrease.

C) the payoffs on interest-rate options are not made at option expiration.

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The payoff on an interest-rate option is made after expiration by the period of the reference interest rate, e.g. 90-day LIBOR or 180-day LIBOR. Bond option values go down when interest rates increase; interest rate option values go up when the underlying rate increases.

Gypsy

An option’s intrinsic value is equal to the amount the option is:

A) in the money, and the time value is the intrinsic value minus the market value.

B) out of the money, and the time value is the market value minus the intrinsic value.

C) in the money, and the time value is the market value minus the intrinsic value.

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Intrinsic value is the amount the option is in the money. In effect it is the value that would be realized if the option were at expiration. Prior to expiration, the option’s market value will normally exceed its intrinsic value. The difference between market value and intrinsic value is called time value.