Options exchange-traded

An equilibrium model of the term structure, of which we reviewed three in the previous section, is a model that is derived from (or consistent with) a general equilibrium model of the economy. They use generally constant parameters, including most crucially a constant volatility, and the actual parameters used are often calculated from historical time series data. Banks commonly also use parameters that are calculated from actual data and implied volatilities, which are obtained from the prices of exchange-traded option contracts. 

Calibrating the model to the current spot rate curve, using volatility parameters that are approximately close enough to result in prices that are near to those of observed exchange-traded options. This is usually the method that is adopted. 

On LIFFE serial expiry months are available for its exchange-traded options serial options are expiry months other than the traditional quarterly months of March, June, September, and December, gilt option expiry months are listed such that the two nearest serial months and the two nearest quarterly months are always available for trading. 

This chapter explores interest rate options—a vitat part of the European fixed income securities market. The first section tooks at exchange-traded options, where 20 bittion worth of bond options and over 250 billion of options on short-term rates change hands every day. Next, we ll look at the flexible OTC markets for interest rate options, including caps, collars, swaptions, and structured products. Finally, having explained the products themselves, we ll move on to explore how they can be used to hedge interest rate risk. 

Unlike the OTC options that we shall be examining later, the premium for these exchange-traded options is not actually paid up-front. Instead, until exercise or expiry, the option buyer and seller are both margined in the same way as with futures positions. The premium of 11,800 is only paid—again through the margining system—when the option expires or is exercised. ... 

Options are traded both on recognized exchanges and over the counter (OTC). Exchange-traded options are standardized plain vanilla contracts OTC options can take on virtually any form. Options traded on an exchange are often written on futures contracts. For example, a gilt option... 

Both OTC and exchange-traded options can be either American or European. Exchange-traded options are available on the following instruments ... 

Futures. Most exchanges trade options on the futures contracts that they trade. These options expire one or two days before the underlying futures do. Some, such as those traded on the Philadelphia Currency Options Exchange, allow cash settlement. This means that when the holders of a futures call exercise it, they are assigned both a long position in the future and the cash value of the difference between the strike price and the futures price. 

Bonds. Exchange-traded options on bonds are invariably written on the bonds futures contracts. One of the most popular exchange-traded options contracts, for example, is the Treasury bond option, which is written on the Treasury futures contract and traded on the Chict o Board of Trade Options Exchange. Options written on actual bonds must be traded in the OTC market. 

The market uses implied volatilities to gauge the volatility of individual assets relative to the market. The price volatility of an asset is not constant. It fluctuates with the overall volatility of the market, and for reasons specific to the asset itself When deriving implied volatility from exchange-traded options, market makers compute more than one value, because different options on the same asset will imply different volatilities depending on how close to at the money the option is. The price of an at-the-money option is more sensitive to volatility than that of a deeply in- or out-of-the-money one. 

Calibration to the current spot rate yield curve, using a pre-specified volatility level and not the volatility values given by the prices of exchange-traded optiOTis. This may result in mispriced bonds and options if the selected volatilities are not accurate ... 

Calibration to the current spot rate curve, using the volatilities implied by the prices of exchange-traded optimis therefore, the model would be implemented using volatility parameters that were exactly similar to those implied by the traded option prices. In practice, this can be a lengthy process ... 

In this section we will explore exchange-traded interest rate options— contracts traded on organised exchanges. In contrast, OTC options offered by banks will be examined in the next section. 

In a later section we will examine why investors and others might want to use these exchange-traded bond options. Before this, however, we will turn our attention towards the other major exchange-traded interest rate product, short-term interest rate options. 

Until recently, the interest rate options market was dominated by OTC transactions—trades executed directly between professional counterparties like banks, insurers, investment institutions, and corporates. However, as Exhibit 17.14 shows, dramatic growth of the exchange-traded markets in recent years has seen them catch up with the OTC markets in terms of notional amounts outstanding, and the two are now neck-and-neck. 

Despite the recent growth of exchange-traded products, the OTC market is still very much a major feature of the interest rate options... 

Statistics on the relative size of the European market for exchange-traded interest rate options are relatively easy to come by, and the Bank for International Settlement (BIS) publishes a regular breakdown of geographic activity. This is summarised in Exhibit 17.15, which shows how notional amounts outstanding on European exchanges have quadrupled over the 3-year period from 1999 to 2002. 

Unfortunately, without a central clearing house to monitor and record all transactions, it is difficult to obtain reliable statistics for the OTC interest rate options market. However, the BIS conducts regular surveys of the markets and publishes a breakdown of notional amounts outstanding by currency (but not by country) of all interest rate derivatives (including swaps, ERAs, futures, as well as options) across all markets (OTC as well as exchange-traded). A summary of this is shown in Exhibit 17.16, from which it can be seen that the size of the euro-denominated market now virtually matches that of the US dollar, signalling the increasing importance of the European interest rate derivatives market. 

EXHIBIT 17.15 Geographic Breakdown of Exchange-Traded Interest Rate Options... 

LME lead options can be traded monthly for up to 15 months forward. Under Exchange rules the declaration or expiry date (the latest date an option can be exercised before it is automatically abandoned), is the first Wednesday in each month, and the prompt (or delivery) date, the third Wednesday. For lead options, the strike price gradation is 20/ton. Traded options in lead have been relatively less popular than those in other metals (see Table 16.1), but their usage has grown. 

In addition to providing some control of price risk, futures and options markets are also very useful mechanisms for price discovery and for gauging market sentiment. There is a world-wide need for accurate, real-time information about the prices established through futures and options trading, that is, a need for price transparency. Exchange prices are simultaneously transmitted around the world via a network of information vendors terminal seiwices directly to clients, thereby allowing users to follow the market in real time wherever they may be. Energy futures prices are also widely reported in the financial press. These markets thus enable an open, equitable and competitive environment. 

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