Chapter+19+Answers+to+end-of-chapter+questions

Chapter+19+Answers+to+end-of-chapter+questions - CHAPTER 19...

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CHAPTER 19 OPTIONS, CAPS, FLOORS, AND COLLARS Chapter outline Basic Features of Options Buying a Call Option on a Bond Writing a Call Option on a Bond Buying a Put Option on a Bond Writing a Put Option on a Bond Writing versus Buying Options Economic Reasons for Not Writing Options Regulatory Reasons for Not Writing Options The Mechanics of Hedging a Bond or Bond Portfolio Hedging with Bond Options Using the Binomial Model Actual Bond Options Using Options to Hedge Interest Rate Risk of the Balance Sheet Using Options to Hedge Foreign Exchange Risk Using Options to Hedge Credit Risk Caps, Floors, and Collars Caps Floors Collars Caps, Floors, Collars, and Credit Risk Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 1
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Solutions to end-of-chapter questions QUESTIONS AND PROBLEMS 1. How does using options differ from using forward or futures contracts? Both options and futures contracts are useful in managing risk. Other than the pure mechanics, the primary difference between these contracts lies in the requirement of what must be done on or before maturity. Futures and forward contracts require that the buyer or seller of the contracts must execute some transaction. The buyer of an option has the choice to execute the option or to let it expire without execution. The writer of an option must perform a transaction only if the buyer chooses to execute the option. 2. What is a call option? What must happen to interest rates for the purchaser of a call option on a bond to make money? How does the writer of the call option make money? A call option is an instrument that allows the purchaser to buy some underlying asset at a prespecified price on or before a specified maturity date. For example, the call option on a bond allows the owner to buy a bond at a specific price. For the owner of the option to make money, the option purchaser should be able to immediately sell the bond at a higher price. Thus, for the bond price to increase, interest rates must decrease between the time the option is purchased and the time it is executed. The writer of the call option makes a premium from the sale of the option. If the option is not exercised, the writer maximises profit in the amount of the premium. If the option is exercised, the writer stands to lose a portion or the entire premium, and may lose additional money if the price on the underlying asset moves sufficiently far. 3. What is a put option? What must happen to interest rates for the purchaser of a put option on a bond to make money? How does the writer of the put option make money? A put option is an instrument that allows the owner to sell some underlying asset at a prespecified price on or before a specified maturity date. The put option on a bond allows the owner to sell a bond at a specific price. For the owner of the option to make money, the purchaser should be able to buy the bond at a lower price immediately prior to exercising the
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This note was uploaded on 08/21/2009 for the course FINS 3630 taught by Professor Yip during the Three '09 term at University of New South Wales.

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Chapter+19+Answers+to+end-of-chapter+questions - CHAPTER 19...

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