Options interest rates

Shirakawa H (1991) Interest Rate Option Pricing with Poisson-Ganssian Forward Rate Cnrve Processes. Mathematical Finance 1 77-94. 

Jarrow, R., 1996. ModeUmg Fixed Income Securities and Interest Rate Options. McGraw-Hill, New York. 

Rebonato, R., 1998. Interest Rate Option Models, second ed. Wiley, Chichester. 

Jarrow, R., Turnbull, S., 1996. Derivative Securities. South-Western Publishing, Cincinnati. Rebonato, R., 1998. Interest Rate Option Models, second ed. Wiley, Chichester. 

When valuing an option written on say, an equity the price of the underlying asset is the current price of the equity. When pricing an interest-rate option the underlying is obtained via a random process that described the instantaneous risk-free zero-coupon rate, which is generally termed the short rate. 

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. 

Before all that, however, we ll start by outlining what interest rate options are, and how they differ from other financial products. 

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. 

While the exchanges offer standardized interest rate options on bonds and 3-month interest rates, the OTC market offers products... 

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

In this way, an interest rate cap allows the borrowing company to benefit when interest rates are low, while protecting the company when interest rates are high. This is marvellous, as it provides the best of both worlds, but such a result does not come free As with other interest rate options, the company would have to pay an up-front premium to purchase the cap. In the example here, this up-front premium might be around 165 bp of the notional principal, i.e., 16,500, which is equivalent to around 35 bp per annum if this cost were spread over the lifetime of the cap. This caps the effective EURIBOR at around 3.35% rather than 3%. Contrast this with the interest rate swap, which does not involve an up-front payment, but penalizes the company with a higher initial interest rate instead. 

Later in the chapter we will examine some of the ways in which swaptions may be used. Before this, however, let s look at the way in which banks can go beyond the offering of vanilla interest rate options, to design and create structured products. 

In addition to using vanilla interest rate options to create the structured products discussed in the previous section, banks can also create structured interest rate derivatives. These can be tailored to meet client needs and include the products discussed in the following paragraphs. In each case, we illustrate the structure by reference to an interest rate cap, but the same principles apply equally well to floors and collars. 

This chapter has so far looked at bond options, STIR options, caps, floors, collars, swaptions, as well as a number of structured products and derivatives, but focusing on the products themselves. In this section we will examine some of the many applications for interest rate options. 

Let s now turn our attention to look at situations where interest rate options are used to hedge against changes in interest rates. To illustrate this, we will consider the case of a company that is borrowing 10 million at 6-month EURIBOR plus 1% for a 5-year period, with the interest rate reset every six months. The floating rate for the first period has just... 

Many option packages—like the zero-cost collar just describe—involve customers buying interest rate options to hedge an adverse market exposure, and then selling other options to offset or eliminate the cost. 

In this chapter we have seen how interest rate options provide banks, investors, companies, and other users of the financial markets, with an immensely flexible set of tools for hedging against or taking advantage of European interest rate movements. 

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