LOS d: Define interest rate caps, floors, and collars.

Q1. An investor who bought a floating-rate security and wishes to establish a minimum periodic cash flow on his investment could:

A)   buy an interest-rate floor.

B)   sell an interest-rate floor.

C)   sell an interest-rate cap.

Q2. 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 puts and calls.

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

Q3. 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.

LOS d: Define interest rate caps, floors, and collars. fficeffice" />

Q1. An investor who bought a floating-rate security and wishes to establish a minimum periodic cash flow on his investment could:

A)   buy an interest-rate floor.

B)   sell an interest-rate floor.

C)   sell an interest-rate cap.

Correct answer is A)

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.

Q2. 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 puts and calls.

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

Correct answer is C)

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.

Q3. 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.

Correct answer is A)

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

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