Question #24 - Reading 31 Valuation of Contingent Claims

Reading: Reading 31 Valuation of Contingent Claims

PDF File: Reading 31 Valuation of Contingent Claims.pdf

Page: 12

Status: Unattempted

Correct Answer: B

Shared Context

- How many of Wood's notes regarding the Black model used to value interest options are correct? A) All three notes are correct. B) Only two of the notes are correct. C) Only one of the notes is correct.

Question

Newman's Comment 2 is best described as:

Answer Choices:

A. correct

B. incorrect as buying a floor is not equivalent to buying interest rate put options

C. incorrect as long floor, short cap would create a pay floating, receive fixed interest rate swap

Explanation

Pay fixed, receive floating swap (payer swap) can be created by going long an interest rate cap and short an interest rate put. A cap comprises of caplets where each caplet is in effect a call option on a FRA. A floor represents a series of floorlets where each floorlet is an interest rate put option. Long floor and short cap with identical strike prices will create receiver swap (i.e., pay floating and receive fixed).

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