Interest Rate Option
An interest rate option is a cash-settled European style option on the yield
of the U.S. Treasury's securities. The interest rate options can be purchased
for short-term, medium-term and long-term rates. The interest rate options
give an investor a chance to make a decision based on views of the direction
of interest rates.
When yield-based options are purchased, a call buyer and a put buyer have
opposite expectations about interest rate movements. An investor buying a
call anticipates that interest rates will go up, thereby increasing the value
of the call position. An investor buying a put expects rates to go down,
which will increase the value of the put. A yield-based call option buyer
will make money if the underlying asset rises above the strike price, plus
the premium paid for the call, before the expiration date. Likewise, a
yield-based put option buyer will make money if the interest rate has
declined below the strike price.
Among the common interest rate option products bought and sold are: the IRX,
a 13-week treasury bill; the FVX, a 5-year treasury note; the TNX, a 10-year
treasury note; and the TYX, a 30-year treasury bond.
The IRX is based on the discount rate of the most recently auctioned 13-week
U.S. Treasury Bill. The new T-Bill is substituted weekly on the trading day
following its auction, usually on a Monday. The others are based on ten times
the yield-to-maturity of the most recently auctioned notes.
The interest rate options market is the largest derivatives market in the
world. It's hard to estimate exactly how large the market is, since the
trading is largely done over-the-counter. Eighty percent of the world's top
500 companies used interest rate options to control their cash flow. This
compares to 75 percent for foreign exchange options, 25 percent for commodity
options and 10 percent for stock options.
Types of Financial Options
|
