Interest Rate Options (1) Flashcards
What are interest rate options?
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
What is a tailor-made interest rate option from a bank?
OTC or negotiated options
Where is a standard intrest option traded?
Traded or exchange-traded options
What does buying an option involve?
Paying a premium to the option seller
What does an option act as?
An insurance polucy and is used by purchaser to compensate for adverse interest rate movements
What if itnerest rate moves favourably?
Option won’t be exercised
Advantage of options (period of time)
Exchange-traded options are valid for a period of time. More flexible than a forward, which only valid on a specific day
Advantage of options (sold)
Exchange traded options can be sold if not needed
Advantage of options (favourable interest)
Any type of option allows company to benefit from favourable interest rate movements
Disadvantage of options (size)
Exchange-traded options are only available in large, standard, contract sizes
Disadvantage of options (premium)
Any type of option will need to be purchased and the premium can be expensive
What is a put option?
An option to pay interest at a pre-determined rate on a standard natiuonal amount over a fixed period in the future
What is a call option?
An option to receive interest at a pre-determined rate on a standard national amount over a fixed period in the future
What does interest rate cap protect against?
Interest rate rises for a borrower
What does interest rate floor protect against?
Interest rate falls for an investor
Collar from a borrower’s perspective?
Cap: Buy a put option, pay a premium
Floor: Sell a call, receive a premium
What happens when the cost of a collar is lower than for buying an option alone )borrower)?
The borrowing company forgoes the benefit of movements in interest rates below the floor limit in exchange for this cost reduction
What does a collar involve for an investor?
A collar involves buying a call option (floor) and selling a put option (higher interest rate than floor)
What does investor do in a collar?
Forgoes the benefit of movements in interest rates above the put option rate
What is an interest rate swap?
An agreement whereby the parties in the agreement exchange interest rate committments
What is the plain vanilla swap?
Swap variable rate debt for fixed rate debt if it’s worried about interest rate rises
What does a swap allow?
A company to organise a new loanw ithout incurring redemption penalties for early repayment of an existing loan
Why bother with a swap?
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
