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

12

Interest Rate Options

INTRODUCTION

Chapters 3 to 6 discussed forward rate agreements (FRAs), interest rate futures, bond futures and interest rate swaps. These are used by banks, traders, corporations and investors to manage exposures to (or speculate on) changes in interest rates. However the potential gains on these products are balanced by the potential losses.

An interest rate option has a different profile. The expected payout to the buyer (ignoring the premium) is positive, since the contract need not be exercised in unfavourable circumstances. This flexibility has a price, the option premium. The premium restores the balance between the buyer and the writer of the option contract.

The products discussed in this chapter are:

• over-the-counter and exchange-traded options on short-term interest rates;

• interest rate caps, floors and collars;

• swaptions (options to buy or to sell interest rate swaps);

• bond options (options to buy or to sell longer-dated debt securities or futures on such securities).

The chapter explores how these products are quoted in the market, and looks at practical applications using a number of short case studies. Chapter 14 has a section on the valuation issues posed by interest rate options.

OTC INTEREST RATE OPTIONS

Since the 1960s central banks and governments around the world have gradually relaxed or abolished controls on currency exchange rates. As a result, the short-term interest rate has become their main weapon against inflation, ...