Interest Rate Options Kayla Sims

Interest Rate Options An investment tool in which the payoff depends on the future level of interest rates Underlying asset is typically a Treasury bond Changes in interest rates: Opportunity: investors can capitalize on their outlook on the changes in interest rates Risk: interest rate moves can adversely affect the value of their investments An interest rate option is an investment tool in which the payoff depends on the future level of interest rates. It gives the investors the chance to invest based upon their views on the direction of interest rates   The underlying asset is typically a treasury bond. Changes in interest rates give investors the opportunity to capitalize on those changes in rates but interest rates can also adversely affect the value of their investments if they do not go in the direction they expected them to. With interest rate options, an investor has a tool to help control interest rate exposure and allows them to take advantage of new investment opportunities.

Interest Rate Options, Cont. Available on the short, medium, and long-term rates Short-term: the 13-week Treasury Bill yield is the recognized benchmark Auctioned weekly Medium-term to long-term rate: 5-year rate (auctioned monthly) 10-year rate (auctioned every 3 months) 30-year rate (auctioned every 6 months) Interest rate options are available on the short, medium, and long term rates. The short term rate is composed of a 13-week treasury bill yield and are auctioned weekly. Medium to long-term rates go anywhere from 5 to 30 years being auctioned off monthly, every 3 months on February, may, and august, or every six months on February and august.

Two Types of Contracts Puts (right to sell) Calls (right to buy) A put buyer anticipates that interest rates will go up (bond prices will go down) Calls (right to buy) A call buyer anticipates that interest rates will go down (bond prices will go up) As with a typical option, there are two types of contracts. A put or call, which is the right to sell or the right to buy. A put buyer anticipates that interest rates will go down, which increases the value of the put position A call buyer anticipates that rates will go up, which increases the value of the call position   Essentially, the investor is just making a bet that interest rates are going to rise or fall.

Comparing Interest Rate Options to Other Options Main difference: Based on interest rates and not on units of specific Treasury bills, notes or bonds. Prices on Treasury obligations, like prices on all fixed-income securities, are inversely related to interest rates. THAT IS When interest rates increase, the price on outstanding securities fall. When interest rates decrease, the price on outstanding securities rise. The main differences between an interest rate option and other options is that investments are based on interest rates and not on units. Also, prices on treasury obligations are inversely related to interest rates. That is, whenever interest rates rise, prices on outstanding treasury securities fall. Whenever interest rates decline, prices on outstanding treasury securities rise. WRITE ON BOARD: interest rates increase, prices decrease. Interest rates decrease, prices increase

Example Consider a Treasury bond held by an investor Par value $1,000, payable at maturity Coupon interest rate of 7% Bond pays $70 a year in interest What if interest rates rise to 10%? Would only need to invest $700 to receive the same payout To see why prices must fall when interest rates rise, consider a Treasury bond held by an investor with a principal or par amount of $1,000, payable at maturity, and a coupon interest rate of 7%. This means that the bond pays $70 a year in interest until maturity, when the principal amount of $1,000 is paid to the holder. If interest rates rise, the amount that would be necessary to invest to receive $70 per year would drop. (If, for example, rates rise to 10%, the necessary investment would be only $700.) The fact that a smaller investment is required to receive the same payment stream explains why bond values fall as long-term rates rise. But the reverse is also true. As long-term rates fall a larger investment is required to receive the same payment.

Quiz Forecast: Falling interest rate on a 5-year Treasury note Objective: To profit from the decline in 5-year interest rates An investor would like to have the opportunity to profit if this forecast is correct. What type of option should he purchase? A purchase of put options would allow the holder to profit if rates do decline because As interest rates decline, the value of the put options should increase. An investor might be able to sell the put options at a profit, thereby closing out the position.

Interest Rate Options Features and Advantages Cash settled European-style exercise Advantages Limited risk for option buying Leverage Hedging Some features of the interest rate option includes a cash settlement so there is no need to own or deliver any treasury securities upon exercise. So if the put or call is exercised, the holder gets the difference between the exercise price and the exercise-settlement value. They are also European-style options in which the holder of the option can exercise the right to buy or sell only at expiration. This eliminates the risk of early exercise and simplifies investment decisions.   Some advantages include limited risk for option buying because the most a buyer can lose if the rates move against him is the premium paid for the option. Interest rate options provide leverage for the investor because they only have to pay a small premium in relation to the value of the underlying security. And lastly, these options are a good source for hedging against adverse interest rate movements but still let the investor benefit from favorable movements. DO NOT CHANGE SLIDES

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References http://www.cboe.com/learncenter/pdf/iro.pdf