Vanilla interest rate options

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. 

Bond traders wishing to hedge the interest rate risk of their bond positions have several tools to choose from, including other bonds, bond futures, and bond options, as well as swaps. Swaps, however, are particularly efficient hedging instruments, because they display positive convexity. As explained in chapter 2, this means that they increase in value when interest rates fall more than they lose when rates rise by a similar amount—just as plain vanilla bonds do. 

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