The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

INTEREST RATE OPTIONS

An option is a contract in which the writer of the option grants the buyer of the option the right, but not the obligation, to purchase from or sell to the writer something at a specified price within a specified period of time (or at a specified date). The risk–return characteristics of an option are explained in Chapter 14, along with the differences between options and futures and the pricing of options.

Exchange-traded interest rate options can be written on a fixed income security or an interest rate futures contract. The former options are called options on physicals. Options on interest rate futures, called futures options, have been far more popular than options on physicals.

Exchange-Traded Futures Options

There are futures options on all the interest rate futures contracts. An option on a futures contract gives the buyer the right to buy from or sell to the writer a designated futures contract at the strike price at any time during the life of the option. If the futures option is a call option, the buyer has the right to purchase one designated futures contract at the strike price. That is, the buyer has the right to acquire a long futures position in the underlying futures contract. If the buyer exercises the call option, the writer acquires a corresponding short position in the futures contract.

A put option on a futures contract grants the buyer the right to sell one designated futures contract to the writer at the strike price. That ...