An interest rate option is a derivative whose contract value is based on interest rates. There are two types of interest rate options, calls and puts. An interest rate call option gives the individual who holds the option to profit off of a rise in interest rates.
When a buyer purchases an interest rate call option, the buyer has the right to pay a fixed rate and receive a variable rate. They do not have the obligation to do so.
If properly utilized, an interest rate call option can be an excellent tool to make a trade based on interest rates and can be a part of a well-executed trading strategy. Interest rate call options are not without their risks, and we will examine them throughout the article.
An interest rate call option differentiates itself from other types of options, as the asset that the investor is purchasing is itself an interest rate. Some examples can be the yield on a Treasury note. Depending on the position an investor is taking (whether you are long or short interest rates), an individual can determine which type of option they wish to purchase. Interest rate call options can be traded over the counter, as well as on some exchanges.
An interest rate option is a derivative whose contract value is based on interest rates.
When a buyer purchases an interest rate call option, the buyer has the right to pay a fixed rate and receive a variable rate.
Banks may use interest rate call options to borrow money at a future date and can hedge their risk by limiting their downside.
How Does an Interest Rate Call Options Work?
When an interest rate call option is purchased, if the interest rate at expiration is higher than the strike rate, the option will be profitable to the purchaser. Generally, in this instance, the buyer will exercise the option. The amount that the purchaser profits is the difference between the current market rate and the strike rate of the option.
Who Should Use Interest Rate Call Options?
Institutions that lend capital, like banks, are often the principal purchasers of interest rate call options. They use them to hedge against changes in the interest rate in times of economic uncertainty.
If a bank or company needs to borrow money at a future date, they can hedge their risk by limiting their downside for the period when they decide to take out a loan. In such situations, the lending institution that has purchased the interest rate call option can limit the total rate that they will be required to pay on interest and can better anticipate and forecast interest payments and costs.
Generally, options are a more advanced instrument that some investors utilize to hedge their positions or leverage their potential profits. Options trading should generally only be done once an investor is well educated on the market and the different instruments they can use to trade it.
Without knowing how to properly hedge different types of options, including interest rate call options, the investor may find themselves buying into a position that they perhaps didn’t mean to.
Risks of Interest Rate Call Options
By creating a poorly hedged position when purchasing interest rate call options, an investor can very quickly find themselves owing large sums of money, depending on how the trade was executed and the margin structure utilized. These types of losses can be catastrophic if not properly hedged.
Interest rate options are very sensitive to the volatility forecasted with interest rates in the market. Call options that are presently “in the money” are the most sensitive to the fluctuations as their strike prices are closely related to the underlying futures price. Due to the sensitivity of these particular types of options to interest rates, it would be prudent for investors to take special attention to the volatility with interest rates.
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