What is an interest rate option?
When interest rates change, an interest rate option gives the person who owns it the chance to make money. When investors buy interest rate options, they can guess where interest rates will go. This type of option is like a stock, put, or call. Interest rate options are contracts that let you choose the rate of bonds, such as U.S. Treasury stocks.
Why would you want to change your interest rate?
Like stock options, interest rate options need a premium to join the agreement. Interest rate increases provide call option owners with the right but not the obligation to profit. The call option owner profits if interest rates rise above the strike price and covers the premium paid to join the contract when the option expires.
A decline in interest rates gives the holder the right but not the responsibility to benefit. If interest rates fall below the strike price and cover the premium, the option is “in the money,” profitable. Options cost 10 times the contract’s Treasury yield. Treasury bond option market value at 6% is $60. Option prices fluctuate with Treasury rates. The option would climb from $60 to $65 if the Treasury note rate reached 6.5%.
Portfolio managers and investors utilize interest rate options to hedge interest rate risk. People also predict interest rates. Interest rate options may be traded utilizing short-term and long-term rates, or the “yield curve.” Treasury bond yields slope like this. Short-term Treasury bonds, such as two-year ones, yield less than 30-year ones. This raises the yield curve. If long-term rates are lower than short-term yields, the curve dips.
One of the largest futures and options marketplaces, CME Group, lets you trade interest rate options. The SEC oversees these choices. Investors may employ Eurodollar futures and Treasury bond and note options.
Interest rate option holders may only utilize their options after they expire, according to European execution regulations. Avoiding financial loss makes choices simpler to make since you can’t exercise them early. Rate option strike prices are returns, not units. No stock is delivered either. Interest rate options are settled in cash, and the spot yield determines the difference between the option’s exercise strike price and its exercise settlement value.
An example of a choice for interest rates
An investor betting on rising interest rates may purchase a 30-year Treasury call option with a $60 strike price and an August 31 expiry date. Call choice adds $1.50 to each contract. The options market charges $150 for one contract and $300 for two. Each contract costs $1.50×100. Why is the premium needed? The owner must earn enough money to pay the premium.
If yields rise by August 31 and the option expires valued $68, the owner gets $8 back, or $800 if multiplied by 100. If the investor had purchased one contract, they would have earned $650, or $800 less the $150 call option fee.
If yields fell on August 31, the call option would be worthless and the owner would lose the $150 premium for one contract. Option value is zero when it’s “out of the money.” The option buyer would lose all their money since it would be worthless.
Like other options, the buyer may close the position before the option expires. One must sell the option on the open market. To finish the deal before expiry, the options seller must purchase another option with the identical strike price and expiration date. However, canceling the arrangement may result in a gain or loss equal to the difference between the option price and the contract premium.
Why Interest Rate Options Are Not the Same as Binary Options
A binary option is a derivative financial product with a set (or maximum) payout if the option expires in the money. If the option expires, the trader loses the money they put into it. So, a binary option depends on a yes or no answer, which is how the word “binary” came to be. Binary options have a time or date when they expire. Traders must make money by ensuring that the underlying product’s price is on the right side of the strike price at the time of expiration.
People sometimes mix up interest rate options with binary options. An interest rate option is also known as a bond option. However, interest rate options differ from binary options in terms of how they work and payout.
What Interest Rate Options Can’t Do
Interest rate options are based in Europe, so they can’t be used as early as American-style options can. However, the contract can be broken by making a counter-contract, which is not the same as taking the option.
When people trade in interest rate options, they need to know a lot about the bond market. This is because both Treasury yields and bond yields have a set rate, and Treasury yields move against bond prices.
Bond prices go down at higher yields because people who already own bonds sell them. After all, their yield is smaller than the current market yield. This means that people who already own bonds don’t want to hold on to their lower-yielding bonds until they mature in a market where interest rates increase. They sell their bonds instead and wait to buy bonds with better yields later. That’s why bond prices decrease when rates increase: people sell their bonds.
Conclusion
- Interest rate options are a type of financial derivative that lets buyers protect themselves against changes in interest rates or bet on which way rates will move. When rates go up, buyers can make money with a call option; when rates go down, they can make money with a put option.
- When you exercise an interest rate option, you get cash equal to the difference between the exercise strike price and the exercise settlement value based on the current spot yield.
- There are European-style execution rules for interest rate options, meaning holders can only use their options when they expire.
