In this chapter I analyse the use of options for managing interest rate risk. The advantage for a firm of using an option versus a linear derivative is that while both mitigate interest rate risk, only options provide the possibility of benefiting from favourable market rate movements. This is in contrast to linear derivatives. The drawback is that the firm has to pay an option premium. The option premium is seen as interest and is recorded in the interest line item of the income statement and the cash flow statement.
There are various types of options. The basic forms are the cap (maximises interest payable) and the floor (minimises interest receivable). The reference rate is ...