Municipalities - All of KB's offers - Interest Rate Option

Interest Rate Option

Interest Rate Option is intended for:

Individuals as well as legal entities including municipalities, nationals as well foreigners, requesting hedging of the interest rate risk resulting from a possible - from the client's point of view - negative development of the given interest rate, and at the same time profit on the opposite development.

Characteristics of Interest Rate Option:

In general, the option represents a right to buy or sell the defined instrument on agreed dates.

The instrument, in case of the interest rate option, is the exchange of payments from the agreed fixed rate for the payments from the determined floating interest rate.

Interest rate option enables to the buyer to hedge his position against the increase or the decrease of interest rates.

The discharge of payments is not connected with one period, but with several repetitive periods.

The buyer hedges his receivables/obligations against an unexpected movement of interest rates, however if the movement of interest rates is opposite, the buyer profits from this development.

Interest rate option is a one-sided deal, payments from the buyer's side are limited to the premium payment (the seller has no interest risk connected with the buyer - after receiving the premium; the buyer can be even a less prosperous subject).

The payment of the premium is usually due 2 business days after the trade date.

The most common maturity ranges from 1 year to 5 years.

The most common interest period is a 3-month one. It can also be 1-month and 6-month.

The deal is always concluded with the Sales dealer by phone.

The client receives deal confirmation containing the agreed parameters of the deal.

Types of interest rate options

Cap

consists of series of call options on interest rate of European type,
the buyer hedges his position against the increase of interest rates (e.g. while having a loan),
the discharge of payments occurs if the reference interest rate exceeds the agreed cap rate on the fixing date,
the amount of payment depends on the fixing of the reference interest rate on fixing days; fixing days are always the beginnings of interest periods,
the payment occurs consequentially after the end of the interest period, to which it relates.

Floor

consists of series of put options on interest rate of European type,
the buyer hedges his position against decrease of interest rates (e.g. while having a deposit),
contraposition to Cap,
the discharge of payments occurs if the reference interest rate comes down under the agreed floor rate on the fixing date,
the amount of payment depends on the fixing of the reference interest rate on fixing days; fixing days are always the beginnings of interest periods,
the payment occurs consequentially after the end of the interest period, to which it relates.

Collar

the Collar buyer is in the position of the Cap buyer and the Floor seller at the same time,
the cap rate is higher than the floor rate (if both the rates were both equal – the interest rate swap would originate),
the Collar buyer receives a payment on the condition that the reference interest rate on the fixing date is above the cap rate,
the Collar buyer sends a payment on the condition that the reference interest rate on the fixing date is bellow the floor rate,
the Collar buyer hedges his float interest obligations in the same way as the Cap buyer; the Collar buyer pays a lower premium by paying the cap premium and receiving the floor premium,
the Collar seller hedges his float interest receivables in the same way as the Floor buyer; the Collar buyer pays a lower premium by paying the floor premium and receiving the cap premium.

Zero Cost Collar

a special Collar variety,
a combination of Cap and Floor (with the equal nominal value, the maturity, interest periods and the reference interest rate), when the cap and the floor rate is chosen in such a manner that the cap premium equals to the floor premium, the premiums get compensated,
the Zero Cost Collar buyer does not pay a premium (it is obvious that, in contrast to the situation when the collar premium is paid, in this case the cap and the floor rate are closer to each other)

Risks

The potential for a profit or a loss from interest rate transactions is influenced by the movement of interest rates.

The purchase of the option involves a smaller risk than its sale. If the buyer of the option is in the advantageous position, the right from the option is exercised automatically for the particular reference period.

The maximal loss is limited by the paid premium.

When selling the option, the risk is significantly higher, the loss of the seller of the option can significantly exceeds the premium received, the risk is unlimited.

The seller of the option accepts the obligation to buy or sell the underlying instrument.

If the option is exercised, the seller of the option finds himself/herself in the situation when the actual market price of the underlying asset sold by him/her can be significantly higher than the Strike, or the other way, the actual market price of the underlying asset purchased by him/her can be significantly lower than the Strike (that he/she is obliged to pay).

Only experienced persons should consider selling the option, and only after they got a detailed knowledge of the conditions and after they hedged a possible risk.

Risks, examples:

The client, that hedges himself/herself against the increase of interest rates, buys the interest option Cap from the bank.

If, on the fixing date, the amount given by the actual value of the reference interest rate is higher than the amount derived from Cap rate, the option is exercised automatically for the particular interest period, and the client receives the difference of these amounts.

In the opposite situation, the option, for the particular interest period, automatically expires unexercised.

The maximal loss of the client buying the option is limited by the paid premium. However, if the deal was concluding for hedging purposes, the client considers this loss as a cost of hedging. The hedging protects the client against such a significant change of the interest rate that could cause him/her serious financial problems.

The seller of the option accepts the obligation to pay, if he/she is in the disadvantageous position, the above mentioned difference of amount derived from the agreed rates. The seller's theoretical loss is unlimited.

Benefits of Interest Rate Option:

securing of loan risk, which can be precisely adapted to suit your specific needs
complete security against expected fluctuation of interest rates and also profit from any possible opposite development
risk for a seller of cap and floor options is limited to the level of the premium paid out (the buyer may have a lower credit score)
significant liquidity of cap, floor and collar type options with the usual characteristics (maturity, currency, reference rate) – thanks to the need to conclude an open position with mirror positions
arrangement of the deal over the phone

Interest Rate Option allows you to:

secure a loan against increase in interest rates
secure deposit against decrease in interest rates
secure liabilities and receivables subject to flexible interest

How can you obtain an Interest Rate Option?

If you are interested in gaining more information about this product or would like to arrange it directly, visit any branch of KB or call free of charge on the KB Info line 800 111 055.