Interest Rate Markets: A Practical Approach to Fixed Income

Chapter 10

Interest Rate Options and Trading Volatility

Options are an important class of products in most financial markets, and fixed income is no exception. An understanding of options allows a trader to use a wider set of tools to express views on the underlying rates and opens up the opportunity to trade volatility, which can provide uncorrelated returns to a rates-trading portfolio. This chapter provides a basic introduction to options, especially in the rates world, and to the concepts underlying trading volatility. Many readers are likely familiar with the basic feature of options: They provide the buyer with the right, but not the obligation, to purchase or sell an asset. The right to purchase an asset is called a call option, while the right to sell the asset is called a put option. The price at which the right can be exercised is called the strike, and the option purchaser tends to have an expiration date to exercise the right. The position of the price versus the strike is known generally as the moneyness. If the strike is equal to the current underlying price, the option is said to be at the money. If the strike is at an unfavorable level compared to the current level (i.e., the option would not be exercised currently), the option is said to be out of the money; the reverse case is called in the money. The amount of value in the option due to the strike difference is known as the intrinsic value, which can be thought of as the profit if the option was exercised immediately. ...