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A company has created an interest rate floor by purchasing an interest rate call option, in order to manage its interest rate exposure.
Which of the following statements concerning the company are true?
A) It will receive a payment if the market rate exceeds the floor rate.
B) It will receive a payment if the market rate is less than the floor rate.
C) It will be required to make a payment if the market rate exceeds the floor rate.
D) It will be required to make a payment if the market rate is less than the floor rate.The answer to this is B but shouldn’t it be a payment i.e Option D because it’s a call/buy option ?
Interest rate options are options to buy or sell (in this case buy) interest rate futures on a future date at a fixed price.
The way they work is a little complicated but they are not examined until Paper AFM.The fact that the question says that they have created a floor (which is what interest rate call options do – but knowing that is not needed) means that they have fixed a minimum interest rate for their borrowing.
Therefore if the actual interest rate is lower than the floor they will effectively receive a payment of the difference.
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