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 RBI bond securities.

An interest rate option has a premium attached to it or a cost to enter into the contract. A call option gives the holder the right, but not the obligation, to benefit from rising interest rates. The investor holding the call option earns a profit if, at the expiry of the option, interest rates have risen and are trading at a rate that’s higher than the strike price and high enough to cover of the premium paid to enter the contract.

Conversely, an interest rate put gives the holder the right, but not the obligation, to benefit from falling interest rates. If interest rates fall lower than the strike price and low enough to cover the premium paid, the option is profitable or in-the-money.

There are two types of options that can be purchased on the exchanges, calls and puts. Interest rate options are used as a hedge for lenders and borrowers in times of economic uncertainty. When an interest rate option is purchased, like an interest rate call option, the purchaser has a right to pay a fixed rate and receive a variable rate. Interest rate options are also available for purchase over the counter and can be considered risky depending on the strike price and expiry date of the option purchased.

Institutions can hedge their risk by limiting their downside for the period when they decide to take out a loan or by creating an interest rate collar. In such situations, the lending institution that has purchased the interest rate call option can limit the total rate that they will be taking on and create more accurate financial forecasts.

These types of options differ from traditional options, which are based on an underlying security. Interest rate options are based on actual rates and are subject to actions by the Federal Reserve or other central banks worldwide. As such, a strong understanding of global markets and the macroeconomic factors that affect interest rates is required before investing in these types of 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.

Risk in Options

An option trading does not come without risk. Options traded without understanding how to structure a trade or how options in general work can result in positions being taken that are over-leveraged or incredibly risky. Interest rate options are no exception to such warnings.

Without understanding properly how interest rate options work, traders could find themselves building a position that becomes unprofitable because they did not understand the position they were building and took on a substantial risk they did not intend to.

Interest rate options are also sensitive to market volatility and fluctuations. Interest rate options purchased that are currently in the money are considered highly sensitive to pricing fluctuations as their strike price is highly correlated to the underlying futures price.