Interest Rate Options (1)

Question 1

What are interest rate options?

Answer 1

Gives an option holder the right to pay or receive interest on an agreed quantity of money, at a specific interest rate on or before a future expiry date

Question 2

What is a tailor-made interest rate option from a bank?

Answer 2

OTC or negotiated options

Question 3

Where is a standard intrest option traded?

Answer 3

Traded or exchange-traded options

Question 4

What does buying an option involve?

Answer 4

Paying a premium to the option seller

Question 5

What does an option act as?

Answer 5

An insurance polucy and is used by purchaser to compensate for adverse interest rate movements

Question 6

What if itnerest rate moves favourably?

Answer 6

Option won’t be exercised

Question 7

Advantage of options (period of time)

Answer 7

Exchange-traded options are valid for a period of time. More flexible than a forward, which only valid on a specific day

Question 8

Advantage of options (sold)

Answer 8

Exchange traded options can be sold if not needed

Question 9

Advantage of options (favourable interest)

Answer 9

Any type of option allows company to benefit from favourable interest rate movements

Question 10

Disadvantage of options (size)

Answer 10

Exchange-traded options are only available in large, standard, contract sizes

Question 11

Disadvantage of options (premium)

Answer 11

Any type of option will need to be purchased and the premium can be expensive

Question 12

What is a put option?

Answer 12

An option to pay interest at a pre-determined rate on a standard natiuonal amount over a fixed period in the future

Question 13

What is a call option?

Answer 13

An option to receive interest at a pre-determined rate on a standard national amount over a fixed period in the future

Question 14

What does interest rate cap protect against?

Answer 14

Interest rate rises for a borrower

Question 15

What does interest rate floor protect against?

Answer 15

Interest rate falls for an investor

Question 16

Collar from a borrower’s perspective?

Answer 16

Cap: Buy a put option, pay a premium

Floor: Sell a call, receive a premium

Question 17

What happens when the cost of a collar is lower than for buying an option alone )borrower)?

Answer 17

The borrowing company forgoes the benefit of movements in interest rates below the floor limit in exchange for this cost reduction

Question 18

What does a collar involve for an investor?

Answer 18

A collar involves buying a call option (floor) and selling a put option (higher interest rate than floor)

Question 19

What does investor do in a collar?

Answer 19

Forgoes the benefit of movements in interest rates above the put option rate

Question 20

What is an interest rate swap?

Answer 20

An agreement whereby the parties in the agreement exchange interest rate committments

Question 21

What is the plain vanilla swap?

Answer 21

Swap variable rate debt for fixed rate debt if it’s worried about interest rate rises

Question 22

What does a swap allow?

Answer 22

A company to organise a new loanw ithout incurring redemption penalties for early repayment of an existing loan

Question 23

Why bother with a swap?

Answer 23

To limit transaction costs. As arranging a swap is significantly cheaper than using a significant termination fee and taking out a loan with new issue costs