Interest Rate Options

• Options allow hedging of liabilities or receivables against adverse interest rate developments – you can profit from positive developments of rates
• Options represent a right (not an obligation) to purchase or sell defined instruments on agreed dates. For interest rate options, such instruments most commonly refer to exchange of payments derived from agreed fixed rate for payments derived from current value of reference interest rate.
• It is a unilateral transaction – payments on the part of the buyer are limited to the payment of the premium
• There is no credit risk for the seller associated with the buyer following the premium collection
• Clients with slightly worse credit rating may also act as buyers
• Options are exercised automatically, provided the option is in-the-money from buyer’s perspective
• Consideration is usually linked to several consecutive periods
• Premium is normally paid 2 business days after trade date
• Transaction maturity usually ranges from 1 to 5 years
• Interest rate period is most commonly 3 months, but may also be 1 month or 6 months

The basic option types are Cap and Floor.

Cap:

• Series of European call interest rate options
• Buyer hedges against rising interest rates (e.g. in case he has a loan with variable interest rate)
• Payment is made, if a reference interest rate exceeds the agreed Cap rate as of the agreed exercise date
• Payment amount is determined by the current value of reference rate as of the agreed exercise date – i.e. interest rate period start dates
• Payment is made after the interest rate period, to which it relates

Floor:

• Series of European put interest rate options
• Buyer hedges against declining interest rates (e.g. in case he has variable–rate deposits)
• It is the opposite to Cap
• Payment is made, if a reference interest rate drops below the agreed Floor rate as of the agreed exercise date
• Payment amount is determined by the current value of reference rate as of the agreed exercise date – i.e. interest rate period start dates
• Payment is made after the interest rate period, to which it relates

Collar:

• Collar buyer acts simultaneously as a Cap buyer and Floor seller
• Cap rate exceeds the Floor rate (interest rate swap exists when both rates are the same)
• Collar buyer receives payments, if the reference interest rate exceeds the Cap rate at the agreed date
• Collar buyer makes payments, if the reference interest rate drops below the Floor rate at the agreed date
• Collar buyer hedges his variable–rate liabilities similarly as Cap buyer; however, Collar buyer pays lower premium overall because he pays Cap premium but also collects Floor premium
• Collar seller hedges his variable–rate receivables similarly as Floor buyer; however, Collar seller pays lower premium overall because he pays Floor premium but also collects Cap premium

The examples given are only illustrative and are intended to describe the operation and use of the product. This is not about past or expected future market developments.

• Profit or loss from interest rate transactions is affected by interest rate fluctuations
• In case the price of an underlying assets changes adversely for the option buyer, the right is automatically disregarded
• Maximum loss for the option buyer is limited to the paid premium
• Risk associated with sold options is much higher than for purchased options
• Loss of the option seller may significantly exceed the received premium
• In case an option is exercised, the seller undertakes to purchase or sell the underlying asset – even if the market price is very far from the strike price
• In case the client already owns the underlying assets, which he undertook to sell, the risk is lower; however, if he does not, the risk is virtually unlimited
• Selling (writing) of interest rate options is only suitable for experienced investors
• Hedging protects clients from significant interest rate fluctuations that could result in significant losses

These products are intended for clients who wish to hedge their interest rate risks associated with adverse interest rate developments.