A bank has made a risky loan to a midsize consumer goods manufacturer. With the weaker economy, the borrower is expected to have trouble repaying the loan. The bank decides to purchase a digital default option. Which one of the following payout patterns does a digital option provide?

Multiple Choice

The option seller pays a stated amount to the option buyer, usually the par on the loan or bond, in the event of a default on the underlying credit.

The option seller pays the buyer if the default risk premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread.

If the option buyer makes fixed periodic payments to the option seller, the seller will pay the option buyer if a credit event occurs.

If the option buyer makes periodic payments to the seller and delivers the underlying bond or loan, the seller pays the par value of the security.

If interest rates change, the option seller will begin making fixed-rate payments to the option buyer.