Interest Rate Options

A type of derivative which has the interest rate as its underlying asset

Interest rate option is a type of derivative which has the interest rate as its underlying asset. They are generally tied to interest rate products like government bonds and money market securities

Investors, both individual and institutional, can speculate as well as hedge (to reduce the risk involved in dealing with a particular asset by taking positions in opposite related assets) against interest rate risk with the help of these kinds of options.

Options trading can be confusing and disastrous for new investors, but for more veteran investors, options trading can prove to be more rewarding, as it provides the opportunity to exert more leverage over overtrading and to apply more high-level strategies like technical analysis.

In this article, we will be covering all the basic concepts revolving around Interest Rate options to more complex topics.

Interest Rate Options Terminology

First of all, it is important to know what all the different concepts of Interest Options mean:

  • Option: It is an option or right to make the transaction for which you pay, but you have no obligation to do so.

  • Underlying AssetThe option is a derivative. Thus, it derives its value from some underlying asset. This underlying asset's value is the determinant of the option's price.

  •  Strike Price: This is also known as the "Agreed-upon price." It is fixed at the time of exercise of the option contract. It doesn't change its value until the point of maturity. 

It is named "strike price" because one will make money once that price point is achieved and outdone. In other words, you will make money through your option contract once your underlying value achieves that price and surpasses it.

  • Fixed period: This is the time required for the options contract to reach the "maturity date," or we can say "expiration date," after which it expires. One can exercise his option at any time in between this period. However, in Europe, one can only exercise it on the day of expiration.

Call and Put Interest Rate Options?

In interest rate options, we have a strike price at which the option holder buys an option. There are two types: call options and put options.

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When it comes to the call option, the buyer has the right (but no obligation) to benefit from the increasing interest rate.

One buys call options when they believe that the security (which is the bond) will rise in value before the exercise date. If that happens, one should buy the security at the strike price and immediately sell it at the higher market price.

If the person is quite bullish about the instrument, they might also consider holding it for a little longer till the price rises even higher. The buyers are therefore called "holders."

Furthermore, dealing with put options gives the buyer the right with no obligation to benefit from the decreasing interest rate. There are exchanges like CME Group, one of the world's largest futures and options exchanges, that generally trade on Interest rate options.

How does one benefit from the Interest Rate Options?

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 Regarding call options, the option holder makes a profit if, at the time of maturity, interest rates have risen and are trading at a higher rate than the strike price after covering the premium paid to enter the contract.

 A call option is said to be "in the money" when the strike price is below the underlying stock value. If a person were to buy the option and sell the stock today, that person would be making money, provided the sale price was more than the premium paid.

Profit usually equals the security proceeds, the strike price, and the premium for the call option being deducted from it. Transactional fees occur as well and must be subtracted. The option's final value is the difference between the strike price and the stock's current market price.

If the price doesn't rise above the strike price, we cannot exercise the option. One's only loss is premium, even if the stock crashes to zero. 

Then why wouldn't investors buy the security instead of buying the option? Buying a call Option gives more leverage. 

  • Tip: If the price rises, one could make a lot more money than if he had brought only security instead. Moreover, investors will lose only a fixed amount if the price drops. As a result of comparatively lower investment, a very high return could be achieved. 

The other advantage can be that one can sell itself if the price rises without ever paying for the security.    

 When investors believe that the asset price is going to drop, they will sell the call option. If it drops below the strike price, they keep the premium. A seller of a call option is also known as a "writer."

 On the contrary, a put option holder gains if, at the time of maturity, interest rates had fallen lower than the strike price rate after covering the premium paid to enter the contract. A put option is "in the money" when the strike price is above the underlying asset value.

Institutional investors usually use this kind of contract to hedge their risk against any risk associated with the bond market's interest rate. It helps minimize their risk in a situation when the Fed tries to lower the interest rate to increase the money supply in the economy.

While the retail investors sometimes use it for speculative purposes, they will eventually be exposed to a very high risk-reward ratio which will result in huge losses for most of them.

Moreover, options have a leverage factor (the ability to multiply the power of your capital), making your option value ten times that of the underlying assets' yield.

For example, let's say an investor is quite bullish about the bond market and buys an option on a government bond with a strike price of $80 and an expiration date of May 31st.

The premium for the call options is $1 per contract. But in the options market, it will be multiplied by 100, so the cost of the contract would be $100. The investor must make enough money to cover the premium to gain any profit.

 If the option is worth $84 at maturity, the investor will earn the difference of 4 dollars, or $400, based on the leverage of 10x. Here the investor would have a profit of $400 minus the $100 premium paid to enter into the call options.

Conversely, if the option went down to $76 at maturity, the investor would lose a difference of $4, which is a $400 loss with leverage of 10x.

In this case, the options would be considered worthless, and the investor will also lose the 100 dollars that he had paid as a premium at the initial stage to enter into the options contract.

Interest Rate Options Limitations

Interest rate options can only be exercised at the time of maturity, which is the European-style exercise provision, while they can be exchanged in the secondary market, which is considered a risky practice. 

This provision helps eliminate the risk of early buying and selling the options contracts.

Investors should have a good knowledge of the bond market before investing in interest rate options. Many factors like political stability, market condition, and investment behavior come into play while determining the yield from a bond market. 

For example, when we talk about a rising or bullish market, they generally opt-out of their investments in the bond market that provides a minimal interest and instead start investing in the securities market where they can make a higher return. 

On the other hand, when deflation occurs, the Feds try to increase the money supply in the economy. They usually decrease the interest rate in this scenario which results in a decrease in the parking of the money bond market.

 Another risk can be competing against hedge funds and other very sophisticated traders.

They have a huge amount of experience with them, and they spend every day analyzing options with the help of different strategies. 

They have hired highly educated quantitative geeks who use calculus to determine the accurate price of an option. They also have sophisticated information systems and computer models that map out potential scenarios. 

Getting into options trading is highly competitive. 

In fact, competitors are on the other side of every trade that is made.  

 In this case, there is no involvement in the delivery of shares, as the amount received by the option holder is only the difference between the strike price and the settlement value.

One will only receive the gain cash from the difference, and no share or other underlying asset is delivered.

Options trading can be risky no matter how simple the strategy is. Many discount brokers require extensive knowledge and assets to begin trading in these sophisticated instruments. 

There are logical risks that can cause investors to lose a substantial amount of money if options strategies are executed improperly. 

One should consult their financial advisor about their risk appetite and investment objectives before considering options trading. 

Although there are some options exercised for hedging purposes, most of them are for speculative purposes and can result in a total loss of invested principal.

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Researched & Authored by Biswajit

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