What are Interest Rate Options?

What are Interest Rate Options?

An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. Investors can speculate on the direction of interest rates with interest rate options. It is similar to an equity option and can be either a put or a call. Interest rate options are option contracts on the rate of bonds like U.S. Treasury securities.

Interest rate options are financial derivatives that allow investors to hedge or speculate on the directional moves in interest rates. A call option allows investors to profit when rates rise and put options allow investors to profit when rates fall.

Why are Interest Rate Options Important?

Interest rate call or put options can be purchased as a way to hedge against interest rate fluctuations or as a trading strategy to bet on which direction interest rates will move in the short or long term. Traders who utilize this strategy may look at macroeconomic indicators that can point towards fluctuations in the interest rate or global events that may lead towards a recession or towards inflation.

Interest rate options are another way traders can broaden their portfolio of tradeable securities in order to create a more diversified trading desk. Also, they are important for banks, which often loan out sizable sums to companies. The banks may wish to cap their potential downside risk should interest rates fall and the loan is not serviced at a rate that they originally anticipated for their cash flows.

Call and Put Interest Rate Options

As said above, there are two types of interest rate options – call and put. A call option gives the investor the right (not obligation) to gain from a rise in the interest rate. The holder of a call option will profit if the interest rate is above the strike rate at the time of the expiry. However, the holder will only make a profit if the interest rate at expiry is high enough to cover the premium cost as well.

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In contrast, a put interest rate option gives the buyer the right (not obligation) to gain from the drop in the interest rates. The holder makes a profit if the interest rate drops below the strike rate and is enough to cover the premium cost as well. Such options are profitable when they are in the money.

Limitations of Interest Rate Options

Since interest rate options are European-based options, they can’t be exercised early like American-style options. However, the contract can be unwound by entering into an offsetting contract, but that’s not the same as exercising the option.

Investors must have a sound grasp of the bond market when investing in interest rate options. Treasury and bond yields have a fixed rate attached to them and Treasury yields move inversely to bond prices.

As yields rise, bond prices fall because existing bondholders sell their previously-purchased bonds since their bonds have a lower-paying yield than the current market. In other words, in a rising-rate market, existing bondholders don’t want to hold their lower-yielding bonds to maturity.

Instead, they sell their bonds and wait to buy higher-yielding bonds in the future. As a result, when rates rise, bond prices fall because of a sell-off in the bond market.

Example of Interest Rate Options

Suppose Mr. A buys a call option with a strike price of $30 and an expiry date of July 31st. The underlying benchmark is the 30-year Treasury, and the premium is $1.

Now assume that by July 31st, the yield goes up, and the value of the option is $35. In this case, the net gain for Mr. A would be $4 ($35 – $30 – $1).

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Now assume if the yield drop by July 31st and the value of the option is now $25. In this case, the call option will expire worthlessly. Mr. A would just lose the premium of $1. An option that expires worthless is usually out-of-the-money (OTM).