Question #9 - Reading 31 Valuation of Contingent Claims

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 4

Status: Unattempted

Correct Answer: B

Shared Context

- Which of the following best explains the difference between an interest rate put option and a put option on a fixed income security? The interest rate put option value: A) decreases if interest rates increase just as the value of a put option on a fixed income security decreases. B) decreases if interest rates increase while the value of a put option on a fixed income security increases if interest rates increase. C) increases if interest rates increase just as the value of a put option on a fixed income security increases.

Question

Which of the following is most likely a reason why dynamic riskless arbitrage is difficult in real markets?

Answer Choices:

A. Securities are subject to insider trading

B. Continuous rebalancing

C. Short sale constraints exist. You are interested in derivative products, particularly with a view to identifying arbitrage opportunities. You start with bond futures: The cheapest to deliver (CTD) bond underlying the T-bond futures contract maturing in five months is a 4.6% T-Bond currently priced at $1,002.33 (full price) per $1,000 par. The CTD paid its last coupon four months ago, and its conversion factor is 1.13. The risk free rate is 2.99%

Explanation

The continuous rebalancing required with dynamic riskless arbitrage is not practical. For one thing, it leads to significant transaction costs. (Module 31.6, LOS 31.j) You are interested in derivative products, particularly with a view to identifying arbitrage opportunities. You start with bond futures: The cheapest to deliver (CTD) bond underlying the T-bond futures contract maturing in five months is a 4.6% T-Bond currently priced at $1,002.33 (full price) per $1,000 par. The CTD paid its last coupon four months ago, and its conversion factor is 1.13. The risk free rate is 2.99%. Peter Wang, one of your colleague, knew of your interest in derivative products advises you to consider interest rate options and swaptions. Wang makes the following comments: Comment 1: An investor having a long position in a call option on a bond has the same position as if he is long an interest rate floor. Comment 2: A borrower of a floating rate loan can create an interest rate collar by buying an interest rate cap and selling an interest rate floor and the cap sets the maximum interest rate payable by the borrower. Comment 3: A payer swaption is the right to enter into a specific swap at some date in the future as the fixed-rate payer. A payer swaption becomes more valuable if an equivalent swap at the market rate is higher than the strike rate.

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