Like all financial derivatives, interest rate options derive their value from an underlying security. In their case, the underlying is normally a reference interest rate or an interest rate index. Just like equity options, interest rate options can be said to provide protection against adverse market moves, while still allowing the holder to benefit from favorable market shifts. In the case of equity options, these shifts would be changes in stock prices or the value of the underlying asset. For interest rate options, the moves would be in the overall interest rate. Thus, this instrument helps companies manage their interest rate exposure.
This note gives a very brief introduction to interest rate options, looking at three basic structures: interest rate caps, interest rate floors, and swaptions.
Before getting into caps, floors and swaptions, however, we'll start with a more basic construction: call and put options on an interest rate. The payoff diagrams of interest rate calls and puts look very much like those of equity calls and puts, with which you should be familiar.1
We'll start with the payoff of an interest rate call option. Let's say that Acme Corporation has issued $100 million bonds, and that the bonds' coupon is not a fixed payment, but based on a floating rate. Acme set its floating rate debt to be an annual payment of LIBOR2 + 3%, no matter what ...