ACCA P4 Interest rate options (part 1)

What are interest rate options. Interest Rate Options

The amount of the payment will be based on the difference between the market rate on the settlement date and the strike rate multiplied by the notional principal, specified in the option contract, to calculate the total payment.

Interest rate option - Wikipedia

Banks are the main sellers of interest-rate options. Clients are mostly corporations who need to borrow at some point in the future, so they want to ensure against adverse changes in interest rates during the interim.

An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. Investors can speculate on the direction of interest rates with interest rate options. Interest rate options are option contracts on the rate of bonds like U. Treasury securities. As with equity options, an interest rate option has a premium attached to it or a cost to enter into the contract.

Because IROs are settled in cash, the client does not need to borrow from the bank that sold it the IRO; if the IRO is in the money and the client exercises the option, then the bank pays the cash settlement to the client. IROs have no secondary market, but if the client wishes to terminate the option before expiration, then the IRO can be sold back to the bank for residual or fair market value.

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IRO premiums are determined by the same factors that affect other options: current market rate of the underlying strike price or rate market volatility, and whether it is a call or put. A call, sometimes called a borrowers' option, increases in value as interest rates rise; a put, sometimes called a lenders' option, increases in value if interest rates fall. The expiry date is when the option can be exercised, which is 2 days before the settlement date, sometimes known as the value date, unless the currency is sterling, in which case the option is exercised on the settlement date.

interest rate option

Interest-rate options differ from what are interest rate options options in that they generally cover an extended duration rather than a single date. Furthermore, because interest rates have a major effect on the economy, central banks prevent interest rates from reaching extremes, so the variation of interest rates is much less than what could possibly occur with equities or other types of options.

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The strike of most options are referred to a strike prices, but the strike of interest-rate options are often called strike rates, since these options go into the money if the interest rate rises above or below the strike rate, depending on the option type. The advantage of IROs over interest rate futures and forward rate agreementshow to work on options correctly other options, is that the holder has the right, but not the obligation, to exercise the option.

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Therefore, if an IRO holder has a cap, but interest rates subsequently decline, then the holder can simply let the option expire and take advantage of the lower interest rates. When an IRO is exercised, the IRO seller pays the IRO buyer the difference between the strike rate and the market rate, which creates an effective interest rate equal to the strike rate plus the option premium.

Caps, Floors, and Collars Caps, floors, and collars are over-the-counter OTC options used extensively to hedge interest-rate risks.

Interest Rate Options

Usually, 1 of the counterparties is a bank. An interest-rate cap sets a maximum interest rate, an interest-rate floor sets a minimum interest rate, and an interest-rate collar sets both a maximum and minimum interest rate by combining a cap and a floor.

These IROs usually consist of strips of options of the same type and usually at the same strike rate, covering a series of successive periods.

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One of these contracts in a cap is called a caplet, while a single contract in a floor is a floorlet. Interest rate caps are sometimes called interest-rate calls because they go into the money if interest rates rise above the strike rate; likewise, interest-rate floors are sometimes called interest-rate puts because they go what are interest rate options the money when interest rates decline below the strike rate.

Interest Rate Options Definition

Collars are established by buying a cap and selling a floor at a lower interest rate. The collar is a type of spread where one option is partly or wholly financed by selling another option. Most interest-rate collars consist of a long cap and a short floor. The income from selling the floor is used to offset, wholly or in part, the cost of the cap. However, if the referenced interest rate drops below the floor, then the collar will lose money proportionate to the amount that the referenced interest rate drops below the floor rate.

An interest-rate cap is simply a series, or strip, of caplets covering successive periods.

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The caplets are priced according to expected future interest rates, so buyers will generally set the strike rates higher than current interest rates to save what are interest rate options the premium, in much the same way that the buyer of a stock option will buy an option with a strike price higher than the current stock price to pay a lower premium.

Likewise, the strike rate of a floor will generally be set below current market rates to save on premiums. For collars, where interest rate caps are bought and floors are sold to finance the caps, strike rate can be selected so that a zero-cost collar can be established.

Interest-rate collars are generally bought as a package from an option dealer. If the reference rate is above the cap rate, then the dealer pays the buyer the net difference between interest rates; if the reference rate is below the floor, then the buyer must pay the dealer the difference between the floor rate and the market rate at expiration multiplied by the notional principal; if the reference rate falls between the floor and the cap, then no payment is made by either party.

An interest-rate swap is a contract in which the buyer of the swap agrees to a fixed rate of interest on a notional principal while the seller agrees to a floating rate, such as the libor, on that same notional principal.

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If a floating rate is higher than the fixed-rate, then the seller pays the buyer; if lower, then the buyer pays the seller. A payer swaption is a European-style option that grants the holder the right to enter into a swaption. If the holder decides to enter into the swaption, then the interest rates are fixed for the contract period, and the buyer may have to pay the seller the difference in interest rates if the floating rate is less than the fixed rate.

Thus, a swaption is less advantageous than a cap, a floor, or a collar, since the decision to exercise or not can only be made once for a payer swaption, but can be made on the expiration date of each startup option or floor.

Thus, the buyer can decide to exercise a caplet or floorlet on each expiration date of a cap or floor.

Interest rate option

Eurodollar Options Eurodollar options give the holder the right to enter into a Eurodollar futures contract. Eurodollars futures prices are based on the anticipated US dollar USD libor interest-rate offered during the contract period on Eurodollar deposits — USD-denominated deposits held in banks outside of the United States.

Eurodollar options can also be used to construct caps and floors.

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CME offers both calls and puts. A call gives the holder the right to enter into a Eurodollars futures contract, which benefits from falling interest rates. A put gives the holder the right to sell a Eurodollar futures contract, which profits from rising interest rates. A put with the same strike price would simply expire worthless.

Interest rate option financial definition of interest rate option

CME also offers mid-curve options, which are options on Eurodollar futures contracts covering 1, 2, and 5-year contracts. The reference rate for a mid-curve option is not a spot rate but a forward rate based on the value of a Eurodollar futures for the forward period. Mid-curve options, so named because they cover the middle of the yield curveare short-dated options with terms of 1 year or less, with quarterly expirations plus the 2 front months.

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There are also weekly mid-curve options that cover the quarterly Eurodollar futures expiring one year from the nearest non-expired quarterly mid-curve. Trading on weekly options terminates on each Friday that is not an expiration day for a quarterly, serial, or mid-curve option. So, in early June, weekly contracts would have the Eurodollar futures for June of the following year as its underlying contract, while one expiring later in the month, would have the September contract for the following year, since by then, the June mid-curve would have already expired.

Mid-curve options based on the 1-year Eurodollar futures are called the red mid-curve options and what are interest rate options the most liquid. Contracts based on the 2-year Eurodollar futures are called the green mid-curve options. Unlike most other options, where the full premium must be paid, the interest rate options offered by NYSE Liffe are purchased like a futures contractin that the buyer deposits an initial margin set by the exchange. The count is managed as variation margin, where the account is mark-to-market daily, incremented or decremented according to the market interest rates for that day.

One such option is for the Euribor Euro Interbank Offered Ratewhich is the key reference rate for short-term euro interest rates.

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Like other financial futuresthe Euribor option has expiration dates in March, June, September, our December plus other near months. Options are for futures that expire in the same month that the option expires, so a March call or put allows the holder to buy or sell a futures contract that expires in March.

Interest Rate Caps