Question #105
Reading: Reading 31 Valuation of Contingent Claims
PDF File: Reading 31 Valuation of Contingent Claims.pdf
Page: 49
Status: Unattempted
Correct Answer: B
Question
To the issuer of a floating rate note, a cap is equivalent to:
Answer Choices:
A. writing a series of interest rate calls
B. owning a series of interest rate calls
Explanation
The issuer of the note is borrowing at a floating rate, and will have higher interest
expenses if rates increase. A cap is equivalent to owning a series of interest rate calls at
the cap rate that will pay the difference between the market rate and the cap rate. If
interest rates increase, the payoff from the calls will compensate the borrower for the
higher interest expenses.