Interest Rate Option Strats

CFA Level III
#1

So, this relates to options being used to hedge borrowing and lending costs.

I have seen multiple questions where the interest rate, the rate that is used to compound the option premium etc have an added x number of basis points.

My question is, when do we need to add these additional basis points?

So far, I have seen the basis points being added for:

  • The actual cost of borrowing/lending.

  • Compounding the premium forward until expiration

I haven’t seen it being used for finding the option payout i.e. Option exercise rate - The actual interest rate.

_ Can someone explain the logic behind this? When do we actually add the additional BP and when do we not add it? _

#2

Can you reference an example or page?

#3

are you talking about calculating effective interest rate on a loan with IR options?

you are correct, the spread (in bps) is added to LIBOR/benchmark rate in determining the future value of option premium and added to the interest of loan assuming no option

#4

There are two simple ways to think of it.

  1. The option is a payout based on LIBOR at expiry and not on LIBOR + spread. Namely, you bought or sold an option on LIBOR so the payout should be in terms of LIBOR.

  2. If you want to think of the option in terms of the actual funding rate (adding the spread) then to do it correctly you’d add the spread to the strike as well and taking the difference would cancel the spread anyways.

Really #1 is the right way to think of it, but if you’re confused on it, #2 can maybe give some of the intuition to why #1 is right.

#5

Thanks for the replies.

I think you guys make sense.

Just to be clear, the only place where the additional BP spread would not be added would be while calculating the option payoff, is it?

#6

you would use the original lending or borrowing rates plus spread to calculate the FV of premium.

Then, the spread on the borrowing or lending (as you’re mentioning) does not affect the option payoff. The option is on LIBOR. If you have a call on libor at 5% and libor at the time of payment is 6%, you are paid on the difference in libor, not the difference in libor + spread. I.e. loan of $100 with a call and libor as mentioned above and a single annual interest payment, your savings (payoff) is $1. You will still pay interest to the lender at libor+x bps but your payment is subsidized by $1. Make sense?

#7

Yep! definitely makes sense. Thanks for the example, I appreciate it.