Question

Question B2. inaurfkses) Suppose a call option with an exercise price of $100 for 1 y/ 3% coupon Australian government bonds can be purchased at $10. a) Draw the option's payoff line, indicating when the option is in-, at- and out-of-the-money b) Suppose you decided to long this option. Explain briefly in which direction bond yields c) Would a typical bank increase or decrease its interest rate risk by buying the above call and at which bond price it breaks even 6 marks) need to move to make this choice a profitable decision (4 marks) option? Hint: first examine if a typical bank is worried about rising or falling interest rates (5 marks)

Answer 1

a) Please refer the image attached for the payoff diagram. The option is in the money when the bond price>$110 , at the money when Bond Price = $110 , and out of the money when the Bond Prices<$110. The breakeven price is $110.

b) With this long call, you will be earning a profit if the bond prices are greater that $110. For bond prices to increase, you will have to hope the yield falls. So Bond Yields should decrease in order to make profits.

c) If a typical bank is worried about rising interest rates, buying the above call option increases the interest rate risk, and vice versa if the interest rates fall.