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Max Perrot, CFA, works for WWF, a mortgage banking company which originates residential mortgage loans. On a monthly basis, WWF issues agency mortgage-backed securities (MBS) backed by their loans. WWF sells the MBS in the open market soon after securitization, but retains the servicing rights to the loans. WWF currently owns the third largest mortgage servicing portfolio in the U.S. Perrot has recently been promoted to Senior Vice President of Asset and Liability Management for WWF. Perrot’s new responsibilities encompass hedging WWF’s newly created MBS prior to their sale, as well as managing the interest rate exposure on the servicing portfolio. Both types of assets are extremely sensitive to changes in interest rates, though not necessarily in the same manner.
Although WWF has retained all of the servicing rights of its loans in the past, they are not opposed to the selling of portions of the portfolio if market conditions are right. WWF’s management wants Perrot in his new position to focus primarily on preserving the value of the servicing portfolio through hedging strategies that are cost effective to execute. Also, any hedge strategy used by Perrot must be extremely liquid in the event that a portion of the servicing portfolio is sold and the hedge needs to be unwound. The upper management of WWF anticipates a period of volatility in interest rates, and they have asked Perrot to project expected returns of a hedged position under a variety of interest rates scenarios.
Perrot’s predecessor lacked experience in hedging with swaps and futures contracts, but he had used them periodically with lackluster results. Through his inaction, he had exposed the firm to significant asset and liability mismatch, which had increased dramatically over the past two years as both production and the servicing portfolio had grown. Perrot, on the other hand, had extensive experience with hedging with derivatives in his prior job. He is familiar with executing hedging strategies utilizing not only swap and futures, but also with options such as caps and floors. He decides that before he presents any potential hedging strategy to WWF’s management, he would first like to bring them up to speed on the basic hedging concepts. He prepares a brief presentation on the relationships between interest rates and options, and outlines some basic hedging strategies. He anticipates many questions that may arise from his presentation, and prepares a handout in a question and answer format.
Which of the following best explains the relationship between interest rate swaps and forward contracts? Interest rate swaps:

A) have the same payoff as a package of forward contracts but not the same value.

B) are equivalent to forward contracts.

C) are equivalent to a series of forward contracts.

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A swap agreement is equivalent to a series of forward contracts. As long as the underlying details are the same, an interest rate swap will have the same payoff and the same value as a series of forward contracts. (Study Session 17, LOS 57.b)

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Which of the following most accurately describes the relationship between an interest rate floor and a bond option? Buying an interest rate floor is equivalent to:

A) selling a portfolio of put options on a bond.

B) buying a portfolio of put options on a bond.

C) buying a portfolio of call options on a bond.

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For a call option on a fixed-income instrument, if interest rates decrease, the fixed-income instrument's price increases. So the call option value increases. This is the same payoff structure as an interest rate floor, which provides a positive payoff if the interest rate is below the strike rate. (Study Session 17, LOS 58.a)

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Assume that a three-year semi-annually settled floor with a strike rate of 8% and a notional amount of $100 million is being analyzed. The reference rate is six-month London Interbank Offered Rate (LIBOR). Suppose that LIBOR for the next four semi-annual periods is as follows:

Period	LIBOR
1	7.5%
2	8.2%
3	8.1%
4	8.7%

What is the payoff for the floor for period 1?

A) $500,000.

B) $250,000.

C) $0.

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The payoff for each semi-annual period is computed as follows:

Payoff = notional amount × (floor rate − six-month LIBOR) / 2

so for period 1:

= $100 million × (8.0% − 7.5%) / 2 = $250,000

(Study Session 17, LOS 58.b)

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Which of the following best explains the difference between an interest rate put option and a put option on a fixed income security? The interest rate put option value:

A) decreases if interest rates increase while the value of a put option on a fixed income security increases if interest rates increase.

B) decreases if interest rates increase just as the value of a put option on a fixed income security decreases.

C) increases if interest rates increase just as the value of a put option on a fixed income security increases.

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An interest rate put option pays off the difference between the strike rate and the current interest rate if that difference is positive. So the value of the interest rate option will be high if interest rates decrease below the strike rate. In contrast, a put option on a fixed income security has a high value if interest rates increase because then the fixed-income security’s price decreases below the value based strike price. (Study Session 17, LOS 58.a)

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A LIBOR based floating rate bond combined with a LIBOR based zero cost collar (a long position in an interest rate cap and a short position in an interest rate floor both at a strike rate such that the collar has zero value) is equivalent to a:

A) call option on a bond.

B) pay-fixed swap position.

C) fixed-rate bond.

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The effective rate above the cap strike and below the floor strike, when combined with the floating rate on a bond, is constant. (Study Session 17, LOS 58.b)

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Which of the following is most likely a reason why dynamic riskless arbitrage is difficult in real markets?

A) Securities are subject to insider trading.

B) Continuous rebalancing.

C) Short sale constraints exist.

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The continuous rebalancing required with dynamic riskless arbitrage is not practical. For one thing, it leads to significant transaction costs. (Study Session 17, LOS 56.e)

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A cap on a floating rate note, from the bondholder’s perspective, is equivalent to:

A) owning a series of calls on fixed income securities.

B) writing a series of interest rate puts.

C) writing a series of puts on fixed income securities.

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For a bondholder, a cap, which puts a maximum on floating rate interest payments, is equivalent to writing a series of puts on fixed income securities. These would require the buyer to pay when rates rise and bond prices fall, negating interest rate increases above the cap rate. Writing a series of interest rate calls, not puts, would be an equivalent strategy. Calls on fixed income securities would pay when rates decrease, not when they increase