24 - Chapter Twenty Four Options, Caps, Floors, and Collars...

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Chapter Twenty Four Options, Caps, Floors, and Collars Chapter Outline Introduction 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 Futures versus Options Hedging 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 on the Balance Sheet Using Options to Hedge Foreign Exchange Risk Hedging Credit Risk with Options Hedging Catastrophe Risk with Call Spread Options Caps, Floors, and Collars Caps Floors Collars Caps, Floors, Collars, and Credit Risk Summary 41
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Solutions to End-of-Chapter Questions and Problems: Chapter Twenty Four 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? A call option is an instrument that allows the owner to buy some underlying asset at a prespecified price on or before a specified maturity date. 3. 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? 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, he 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 maximizes 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. 4. What is a put option? 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. 5. 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? The put option on a bond allows the owner to sell a bond at a specific price.
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This note was uploaded on 10/25/2010 for the course FIN 398 taught by Professor Ray,jackson during the Spring '10 term at UMass Dartmouth.

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24 - Chapter Twenty Four Options, Caps, Floors, and Collars...

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