Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 12. Interest Rate Options

INTRODUCTION

In Chapters 3, 5 and 6 we explored products such as forward rate agreements (FRAs), interest rate futures and interest rate swaps. FRAs and futures can be used by banks, traders, corporations and institutional investors to manage exposures to or speculate on changes in interest rates. However the potential gains are balanced by the potential losses. The buyer of an FRA is paid compensation if the interest rate for the contract period turns out to be above the contractual rate, but otherwise has to compensate the seller. If the contractual rate is the expected rate for the period then the expected payout from the deal is zero. Interest rate futures have similar characteristics, although settlement takes place daily and because of the different quotation method it is the short who is paid out if interest rates rise.

A standard or 'vanilla' interest rate swap is the exchange of fixed for floating cash flows on regular dates. The initial floating or variable cash flow is based on a cash market interest rate (normally LIBOR). The subsequent cash flows are based on a sequence of future interest rates. As such, it can be priced using the first cash market rate and the interest rate futures that best match its payment periods. The fixed rate on a par swap is the rate that makes the present values of the expected future cash flows equal to zero. The expected payout on a par swap is zero. An interest rate option is different. The expected payout ...