"Derivative"exercise:The binomial model
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Questions 1:
Conceptually, a forward rate agreement most likely allows a company that wants to invest money in the future to lock in a rate by making a:
A 、variable payment and receiving a fixed payment.
B、 fixed payment and receiving a different fixed payment.
C、 fixed payment and receiving a variable payment.
Questions 2:
In the binomial model, the difference between the up and down factors bestrepresents the:
A 、volatility of the underlying.
B 、moneyness of an option.
C、 pseudo probability.
A is correct. Forward rate agreements are forward contracts that conceptually allow lenders to lock in a fixed payment on a future investment by receiving a known payment and making an unknown payment that offsets the unknown future interest payment.
B is incorrect. This does not offset the unknown interest payment in the future and thus does not lock in a rate.
C is incorrect. Making a fixed payment and receiving a variable payment looks in a borrowing rate in a forward rate agreement.
A is correct. The volatility of the underlying is captured in the binomial model by the difference between the up and down factors.
B is incorrect. The moneyness of an option is given by the difference between price of the underlying and exercise price.
C is incorrect. The difference between the up and down factors is only one part (the denominator) of the formula for the pseudo probabilities.
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