Interest rate options

Could someone help me understand the concept and use of an interest rate option?

Is it for example like this: when you’re bondholder you receive fixed interest payments from the borrower. In order to mitigate the risk of missing out on increased market interest rates you buy a interest rate call option? But how does it work when you exercise this? You get one interest payment according to the market rate and all the other are back to the fixed rate?

Or can you buy an interest call option just for ‘speculative’ reasons? So without owning the bond? But then what is the interest payment based on?

Lastly, Investopedia says: “an interest rate call option is a derivative in which the holder has the right to receive an interest payment based on a variable interest rate, and then subsequently pays an interest payment based on a fixed interest rate.” Which make it sound more like a swap, because there are payments going both ways?

As you can see… I’m lost. Thanks for your help!

You can check out this Investopedia article, probably you missed the right link.

About interest rate options:

They are like any other option, can be call or put and each one can be long or short.

Interest rate options are used to hedge risk from unexpected changes in the yield curve (whatever they were to be that could affect your bonds value, your leverage costs, etc).

Also, they can be used to speculate easily because the payoffs of interest rate options does not require to settle the whole capital of the contract, but just to pay the gain or loss of the option.

Obviously, do not forget that in any option (that gives the opportunity to exercise a right, but not the obligation) you will need to pay (long) or receive (short) a premium at each option bought or sold correspondingly.

Simple example:

You need to buy a machine valued at 5,000 in September 2018. Today, your favorite bank offers an interest rate of 4%. You are concerned that interest rates will go up to 7% in September, so you decide today to buy an interest rate call with a strike rate of 5%.

September has arrived and you quote the loan again with your bank and it says the rate is 6% now. As the market rate is higher than your strike rate of your call, your call is in the money, so you decide to exercise it. The writer of the call will pay you 1% of 5,000 (or settle a loan of 5,000 at 5% interest rate), therefore you have won 1% against the market.

In a parallel universe, the rate remained at 4%, so you would be insane if you exercised the call, so your call expires out of the money (worthless).

Summing up, we can see options almost like insurance.

Hope this helps a little bit.

This is an option not a swap. Thus one side (an option seller receives a premium) and another side receives a payoff if the option is ITM on predetermined date.

Derivatives always may be used for speculative, not only hedging purpose. Option payoff (strike) is always based on market IR (LIBOR) + BPS which future movements is not known ex ante.

It is supposed that an option holder hedges its basic position on bond (loan). If is long in bond (loan), it is probably financial institution and will hedge this position (IR exposure) with IR Put option. If it is shorting the bond, it is probably the issuer who can hedge the exposure with IR Call.

long Cap = gives you the right to enter into the fixed rate payer side of a loan

long floorlet = gives you the right to force the short side into being the fixed rater payer

by fixed I mean the exercise percentage.