Interest rate options

Interest rate options are a tool for hedging interest rate risk.

Characteristics

Options on futures

Interest rate options are options to buy or sell interest rate futures contracts. Therefore all the futures information is still valid, for example:

• The standard size of the contracts, i.e. £500,000, $1,000,000 etc.
• The duration of the contract, i.e. 3 month contracts.
• The appropriate tick value, i.e. £12.50, $25.00.
• Maturity dates end of March, June, September and December.

Put or call?

A call option gives the holder the right to buy the futures contract.

A put option gives the holder the right to sell the futures contract.

You always buy the option - buy the right to buy or buy the right to sell.

Exercise prices and premium costs

When you are setting up the hedge position for an option you have a number of prices (exercise prices) from which to choose (as opposed to the futures position where you buy or sell at the current price).

There are various ways of choosing an exercise price.

•  In an exam question, you may be told which exercise price to use, so check that first.
• One common way is to choose the exercise price closest to the current interest rate, so if the current interest rate were 6.00% then an exercise price of 94.00 would be chosen.
• Alternatively, if we assume that the options are to be exercised then the way to find the exercise price that will result in the highest net receipt and minimum total interest payment.

Options hedging calculations

Step 1: Set up the hedge by addressing 4 key questions:

• Do we need call or put options?
• How many contracts?
• Which expiry date should be chosen?
• Which strike price / exercise price should be used?

Step 2: Contact the exchange. Pay the upfront premium. Then wait until the transaction / settlement date.

Step 3: On the transaction date, compare the option price with the prevailing market interest rate to determine whether the option should be exercised or allowed to lapse.

Step 4: Calculate the net cash flows - beware that if the number of contracts needed rounding, there will be some borrowing or deposit at the prevailing market interest rate even if the option is exercised.

Options terminology: Caps and floors

Caps

We have seen above that a borrower will hedge against the risk of interest rate rises by buying a put option over interest rate futures.

A cap is another name for this put option over interest rate futures.

Floors

Similarly, a depositer will hedge against the risk of interest rate falls by buying a call option over interest rate futures.

Such an option can also be called a floor.

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Tags:	interest rate options;caps;floors