Question

1. In the 1960s, life insurance companies were signing up baby boomers for whole life policies. A feature often included in the policies was the right to borrow against the cash value of the policy at a fixed rate of interest, say 8 percent. At the time, with interest rates of 3 to 4 percent, this feature didn’t seem important. However, this feature proved extremely valuable to the insured, when interest rates soared to double digits in the early 1980s. Suddenly, the baby boomers were able to borrow at 8 percent and invest at 12 percent, while the insurance companies had to borrow at rates higher than 8 percent in order to honor their contracts. Many insurers were threatened with insolvency because of this feature in their contracts.
2. 1. What kind of option position did the insurance companies have? (Long or Short? European or American? Put or Call?) Explain your answer.
   2. What is the underlying asset for the options in this real-life example?

Answer 1

Answer to Part (1)

Let us first understand what are options, call options, put options , long position , short position , American and European Options .

An option gives the option-holder the right but not the obligation to buy or sell the underlying asset at a fixed price determined today at a specified date in the future.

A Put Option gives the option-holder the right but not the obligation to sell the underlying asset at a pre-determined price at a specified date in the future.

A Call Option gives the option-holder the right but not the obligation to buy the underlying asset at a pre-determined price at a specified date in the future.

A Long Position in a Call or a Put Option is the Option Buyer

While a Short Position in a Call or a Put Option is the Option Seller

An European Option is a type of Option that can be excercsied only at its expiration date while an American Option can be excercsied anytime before expiry.

Since in the given information the insured had the right but not the obligation to borrow at a specified interest rate and they exercised this when the interest rate rose so they have along(buy) position in a call option.The option could be exercised anytime before its expiry so it is a call option

Thus the insurance companies have a short position in an American Call Option as they have the obligation and not the right to lend at the pre-specified interest rate and is in effect selling the interest rate.

Answer to Part (b)

The underlying asset in this option is the interest rate.as the insured and the insurer are buying and selling the interest rate.