Derivatives

CHAPTER 38T-Bond Option, Caps, Floors and Collar

Aims

• To examine the use of options on T-bonds (T-notes) and options on T-bond futures and Eurodollar futures.
• To show how interest rate caps (floors) can be used to set an effective upper (lower) limit on the interest rate to be paid (received) in the future on a LIBOR bank loan (deposit).
• To show how a collar is used to limit the maximum and minimum interest rates payable in the future, on an existing LIBOR bank loan or bank deposit.

Interest rate options have payoffs determined either by the interest rate itself (caps and floors) or the payoff is based on the price of an asset (e.g. bond price or bond futures price). There are a wide variety of interest rate derivatives which can be used either for speculation on the future direction of interest rates (or bond prices) or to hedge/insure against future changes in interest rates (or bond prices). Many interest rate derivatives are OTC instruments while some are traded on organised exchanges. In Chapters 40 and 41 we examine in more detail how fixed-income derivatives are priced but here we concentrate on describing how these derivatives are used.

38.1 OPTIONS ON T-BONDS AND EURODOLLARS

A European option on a T-bond gives the holder the right to buy or sell a T-bond at some time in the future at a certain known strike price K. The payoff to a long call option on the T-bond is where is the market price of the bond at maturity of the option contract. A T-bond option can be used ...