CHAPTER 12: BOND AND INTEREST RATE OPTION CONTRACTS
PROBLEMS AND QUESTIONS WITH SOLUTIONS
Note on Problems: A number of the problems can be done in Excel by writing a program
or using the Option Strategy Excel Program available on the website.
1. Show graphically and in a table the profit and T-bond price relationships at
expiration for the following positions on OTC T-bond options. In each case,
assume that the T-bond spot call and put options each have exercise prices of
$100,000 and premiums of $1,000, and that there is no accrued interest at
expiration. Evaluate at spot T-bond prices of $90,000, $95,000, $100,000, $105,000,
and $110,000.
a. A straddle purchase formed with long positions in the T-bond call and put
options.
b. A straddle write formed with short positions in T-bond call and put options.
c. A simulated long T-bond position formed by buying the T-bond call and selling
the T-bond put.
d. A simulated short bond position formed by selling the T-bond call and buying
the T-bond put.
e. A strip purchase formed with long positions in one T-bond call and two puts.
f. A strap write formed with short positions in two T-bond calls and one put.
Tables (graphs not shown)
b. Straddle Write
fT Short Put Profit Short Call Profit Total Profit
Max[100,000 - fT,0] - 1,000 1,000 - Max[fT-100,000,0]
$90,000 -$9,000 $1,000 -$8,000
$95,000 -$4,000 $1,000 -$3,000
$100,000 $1,000 $1,000 $2,000
$105,000 $1,000 -$4,000 -$3,000
$110,000 $1,000 -$9,000 -$8,000
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2. Assume that there is an OTC T-bond spot call with an exercise price of $100,000
and premium of $1,000 and an OTC T-bond spot call option with an exercise price
of $101,000 and premium of $500. Also assume the options expire at the same time
and that there is no accrued interest at expiration. Show graphically and in a table
the profit and T-bond price relationships at expiration for the following positions
on the OTC T-bond options. Evaluate at spot T-bond prices of $95,000, $97,500,
$100,000, $102,500, $105,000, and $107,500.
a. A bull call spread formed by buying the 100 T-bond call and selling the 101 T-
bond call.
b. A bear call spread formed by buying the 101 T-bond call and selling the 100 T-
bond call.
Tables (graphs not shown)
3. Show graphically and in a table the profit and T-bill futures price relationships at
expiration for the following positions on T-bill futures options. In each case,
assume that the T-bill futures call and put options each have exercise prices of
$987,500 (IMM index = 95) and premiums of $1,250. Evaluate at spot discount
yields at expiration of 6.5%, 6%, 5.5%, 5%, 4.5%, 4%, and 3.5%.
a. A straddle purchase formed with T-bill futures call and put options.
b. A straddle write formed with T-bill futures call and put options.
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c. A simulated long T-bill position formed by buying a T-bill futures call and
selling a T-bill futures put.
d. A simulated short T-bill position formed by selling a T-bill futures call and
buying a T-bill futures put.
Tables (graphs not shown)
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4. Show graphically and in a table the profit and LIBOR relationships at expiration
for the following positions on interest rate options. In each case, assume that the
interest rate call and put options each have exercise rates of 7%, the LIBOR as
reference rates, notional principals of $20 million, time period of .25 per year, and
premiums of $25,000. Evaluate at spot discount yields at expiration of 5%, 5.5%,
6.0%, 6.5%, 7%, 7.5%, 8%, 8.5%, and 9.0%.
a. An interest rate call purchase
b. An interest rate put purchase
c. An interest rate call sale
d. An interest rate put sale
Tables (graphs not shown)
5. Explain the role and functions of the Option Clearing Corporation.
The Option Clearing Corporation (OCC) guarantees the option writer's position and acts
as an intermediary. As an intermediary, the OCC breaks up each option contract after the
trade has been completed. Thus, after an option contract is initiated, the OCC steps in
and becomes the effective buyer to the seller and effective seller to the buyer. By
breaking up each contract, the OCC makes it easier for option investors to close their
positions by simply making an offsetting order.
6. Suppose in February, Ms. X sold a June 95 Eurodollar futures call contract to Mr.
Z for 5, then later closed her position by buying a June 95 Eurodollar futures call
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for 6 from Mr. Y. Explain how the OCC would handle these contracts. Use actual
prices and not the index values.
(1) After Ms. X sold a June 95 Eurodollar futures call (X = $987,500) to Mr. Z for 5
(C = (5)($250) = $1,250), the OCC would break up the contract and would record
the entries (1) and (2) (shown in the table), in its computers.
(2) When Ms. X later bought the June 95 Eurodollar futures call for 6 (C = (6)($250)
= $1,500) from Mr. Y, the OCC would break up the contract and record entries (3)
and (4) in its computers (see table). Entry (3), giving Ms. X the right to go long at
95 (X = $987,500), would cancel out entry (2), identifying her responsibility to go
short at 95 (X = $987,500) if assigned.
(3) Thus, Ms. X's purchase of June 95 Eurodollar futures call from Mr. Y offsets her
initial sale of June 95 Eurodollar futures call, thus closing her positions. By her
transactions, Ms. X incurs a $250 loss by selling the call at 5 (C = $1,250), then
buying at 6 (C = $1,500). The OCC would, in turn, have Mr. Z's long position
covered by Mr. Y's short position.
Entry OCC Records
1. Mr. Z has the right to go long in June 95 Eurodollar futures from the OCC
(X = $987,500).
2. Ms. X has the responsibility to go short in June 95 Eurodollar futures if
assigned by the OCC.
3. Ms. X has the right to go long in June 95 Eurodollar futures from the OCC.
4. Mr. Y has the responsibility to go short June 95 Eurodollar futures if
assigned by the OCC.
7. Suppose Eastern Bank offers Gulf Refinery a $150 million floating-rate loan to
finance the purchase of its crude oil imports along with a cap. The floating-rate
loan has a maturity of 1 year, starts on December 20th, and is reset the next three
quarters. The initial quarterly rate is equal to 10%/4; the other rates are set on
3/20, 6/20, and 9/20 equal to one fourth of the annual LIBOR on those dates plus
100 basis points: (LIBOR % + 1%)/4. The cap Eastern Bank is offering Gulf has
the following terms:
Three caplets with expiration dates of 3/20, 6/20, and 9/20
The cap rate on each caplet is 9.5%
The time period for each caplet is .25 per year
The payoffs for each caplet are at the interest payment dates
The reference rate is the LIBOR
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Notional principal is $150 million
The cost of the cap is $500,000
Show in the table below the companys quarterly interest payments, caplet cash
flows, hedged interest payments (interest minus caplet cash flow), and hedged rate
as a proportion of a $150M loan (do not include cap cost) for each period (12/20,
3/20, 6/20, and 9/20) given the following rates: LIBOR = 10% on 3/20, LIBOR =
9.5% on 6/20, and LIBOR = 9%.
1 2 3 4 5 6 7
Date LIBO Cap Payoff on Loan Interest Hedged Hedge Unhedged
R Payment Date on Payment Debt d Rate Rate
Date
12/20/Y1
3/20/Y1
6/20/Y1
9/20/Y1
12/20/Y2
8. XU Trust is planning to invest $15 million in a Commerce Bank one-year floating-
rate note paying LIBOR plus 150 basis points. The investment starts on 3/20 at 9%
(when the LIBOR = 7.5%) and is then reset the next three quarters on 6/20, 9/20,
and 12/20. XU Trust would like to establish a floor on the rates it obtains on the
note. A money-center bank is offering XU a floor for $100,000, with the following
terms corresponding to the floating-rate note:
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The floor consists of three floorlets coinciding with the reset dates on the note
Exercise rate on the floorlets = 7%
Notional principal = $15 million
Reference Rate = LIBOR
Time period on the payoffs is .25
Payoff is paid on the payment date on the note
Cost of the floor is $100,000 and is paid on 3/20
Calculate and show in the table below XU Trusts quarterly interest receipts,
floorlet cash flow, hedged interest revenue (interest plus floorlet cash flow), and
hedged rate as a proportion of the $15 million investment (do not include floor
cost) given the LIBORs shown in the table.
1 2 3 4 5 6 7
Date LIBOR Interest on Floor Payoff Hedged Hedged Unhedged
FRN on on Payment Interest Rate Rate
Payment Date Income
Date
3/20 .075
6/20 .07
9/20 .065
12/20 .06
3/20
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9. Suppose Commerce Bank sells XU Trust a two-year $15 million FRN paying the
LIBOR plus 150 basis points. The note starts on 3/20 at 9% and is then reset the
next seven quarters on dates 6/20, 9/20, and 12/20. Suppose a money center bank
offers Commerce Bank a cap for $200,000, with the following terms corresponding
to its floating-rate liability:
The cap consists of seven caplets coinciding with the reset dates on the note
Exercise rate on the caplets = 7%
Notional principal = $15 million
Reference Rate = LIBOR
Time period on the payoffs is .25
Payoff is paid on the payment date on the note
Cost of the cap is $200,000 and is paid on 3/20
a. Show in a table Commerce Banks quarterly interest payments, caplet cash
flows, hedged interest cost (interest minus caplet cash flow), and hedged rate as
a proportion of the $15 million FRN loan (do not include cap cost) for each
period given the following rates: LIBOR = 7.5% on 3/20, 8% on 6/20, 9% on
9/20, 8% on 12/20, 7% on 3/20, 6.5% on 6/20, 6% on 9/20, and 5.5% on 12/20.
b. To help defray part of the cost of the cap, suppose Commerce Bank decides to
set up a collar by selling a floor to one of its customers with a floor rate of 6.5%
for $150,000 with the following terms:
The floor consists of seven floorlets coinciding with the reset dates on the
note
Exercise rate on the floorlets = 6.5%
Notional principal = $15M
Reference Rate = LIBOR
Time period on the payoffs is .25
Payoff is paid on the payment date on the note
Cost of the floor is $150,000 and is paid on 3/20
Evaluate Commerce Banks hedged interest costs using the collar.
c. Define another interest rate option position Commerce Bank might use to
defray the costs of its cap-hedged floating-rate liability.
a.
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b.
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c. Instead of selling a floor, the bank could sell a similar cap with a higher exercise rate.
A long position in a cap and short position in a similar cap with higher exercise rate is
referred to as a corridor.
10. Explain intuitively and with an example why call and put options are more
valuable the greater their underlying securitys variability.
Since long call and put option positions are characterized by almost unlimited profit
possibilities but limited losses, option holders would prefer more volatility in the
underlying security rather than less. For a call option, greater variability suggests, on the
one hand, a chance the security will increase substantially in price, causing the call to be
more valuable. On the other hand, there also is a chance the security will decrease
substantially. This, though, is inconsequential to the holder, since his losses are limited.
For a put option, greater variability implies a more valuable put if the stock decreases,
with losses limited if it increases. Thus, the more volatile the underlying security, the
more valuable is the option.
11. Explain why option holders should, in most cases, close their options instead of
exercising. Under what condition would it be beneficial to exercise a call option
early?
If a holder sells the option, she will receive a price that is equal to the intrinsic value plus
the time value premium; if she exercises, though, her exercise value is only equal to the
intrinsic value, Thus by exercising instead of closing, she loses the time value premium.
Thus, an option holder in most cases should close instead of exercise.
An exception to the rule of closing instead of exercising would be a case in which the
underlying security pays a coupon (or in the case of a stock, a dividend) that exceeds the
time value premium.
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