LOS e: Compute and interpret option payoffs, and explain how interest rate option payoffs differ from the payoffs of other types of options.

Q1. 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.

Q2. 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)   An equity call option holder receives cash in the amount by which the exercise price is greater than the strike price.

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

Q3. The value of an interest-rate call option at expiration is zero or the:

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

B)   present value of, the 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.

Q4. 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.

LOS e: Compute and interpret option payoffs, and explain how interest rate option payoffs differ from the payoffs of other types of options. fficeffice" />

Q1. 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.

Correct answer is B)       

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

Q2. 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)   An equity call option holder receives cash in the amount by which the exercise price is greater than the strike price.

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

Correct answer is C)

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.

Q3. The value of an interest-rate call option at expiration is zero or the:

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

B)   present value of, the 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.

Correct answer is B)

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.

Q4. 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.

Correct answer is C)

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.

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