Question

1. At all spot rates above the strike price, the purchase of the CALL option would choose to?

   		a) do nothing
   		b) not exercise the option
   		c) to exercise or not - no difference
   		d) exercise the option

2)

1. For the following problem, consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.

   •    Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.

   •    Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%

   •    Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.

   Choosing strategy #2 will:

   		A) guarantee the lowest average annual rate over the next three years.
   		B) eliminate credit risk but retain repricing risk.
   		C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
   		D) preclude the possibility of sharing in lower interest rates over the three-year period.

Answer 1

1)
When the spot price is greater than strike price, purchaser will exercise the call option. Call option is a right to buy at strike price. If the spot price is higher than strike price, call purchaser will exercise the option and buy at strike price and sell at higher spot price. This will give him/her gains.

Hence, the correct option is d) Exercise the option.

2)

The correct option is C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.

There is a possibility the LIBOR can be low for the next three years. However, there exist repricing risk. Repricing risk is risk of changes in interest rate. Also, it will maximize combined credit.

Reason why other option are wrong

In strategy 2, borrowing is on LIBOR + 2%, LIBOR is fluctuating rate which can either go up or go down and hence, there is no guarantee that interest rate will be lowest for the next 3 years. Therefore, option A is wrong. Also there is credit risk as the LIBOR keep on changing annually. Therefore, option B) is wrong.

There is possibility that LIBOR rate can be lower than the fixed rate and hence, it do not preclude the possibility of sharing in lower interest rate over the three year period and hence option D) is wrong.

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