Interest Rate Options

Investors can use interest rate options to speculate on the direction of interest rates or to hedge a portfolio of Treasury securities. Investors can establish a position in either price based options or rate based options to achieve their objective.

Price Based Options

Priced based options are used by investors to speculate on or to hedge against a change in Treasury securities’ prices. As interest rates change, the prices of Treasury securities will move in the opposite direction. Interest rates and bond prices are inversely related to each other. An investor who believes that interest rates are likely to rise would purchase price based puts or sell price based calls. Alternatively, an investor who believes that rates are likely to fall will purchase price based calls or sell price based puts. Priced based options on Treasury notes and bonds are based on a $100,000 par amount of a specific Treasury note or bond. Price based options on Treasury bills are based on $1,000,000 par value. Price based options, when exercised, will result in the delivery of the specific security.

Premiums Price Based Options Treasury Notes and Bonds

Treasury notes and bonds are priced as a percentage of par down to 32nds of 1 percent. Price based options are also quoted as a percentage of par down to 32nds of 1 percent.

Example:

A May Treasury bond 103 call on a 7% Treasury maturing in October 2015 is quoted at

1.16. The premium is calculated as follows:

1.16 = 1 16/32 % X $100,000

1.5% x $100,000 = $1,500

The investor will pay $1,500 for the right to purchase this 7% Treasury bond maturing in

October 2015 at 103.

To determine the investor’s potential profit and loss on price based options, use the same rules that were applied to equity options. This investor will breakeven if this bond is

trading at 104.16 at expiration. Priced based options settle with the delivery of the under- lying security two business days after the option has been exercised. The buyer must pay the exercise price plus accrued interest on the underlying security.

Premiums Priced Based Options Treasury Bills

Priced based options for Treasury bills are based on $1,000,000 par value of a 13-week Treasury bill that has yet to be issued. The option’s premium is quoted as an annualized percentage of the $1,000,000 par value. Because there are four 13-week quarters in a year, the premium would have to be divided by 4 to determine the amount owed or due.

Example:

A priced based Treasury bill option is quoted at 1%

1% x $1,000,000 = $10,000

$10,000 / 4 = $2,500

 

TAKE NOTE!

Each basis point in the premium quote for a Treasury bill option equals $25.

Because the Treasury bill covered by the option has not yet been issued, an investor may not write a covered Treasury bill call. If a Treasury bill option is exercised, the Treasury bills will be delivered the following Thursday. Because Treasury bills are issued at a discount, the buyer does not owe accrued interest.

Rate Based Options

An investor may speculate on interest rates or hedge a portfolio by using rate based options. Rate based options are open for trading, based on the most recently issued Treasury bill, note and bond. Because an investor cannot deliver a “rate”, rate based options settle in cash and use a contract multiplier of 100. Rate based options have a direct correlation to a change in interest rates. An investor who believes that rates will rise would purchase rate based calls or sell rate based puts. An investor who believes that rates are going to fall would purchase rate based puts or sell rate based calls.

Example:

An investor believes that rates are going to rise and purchases 1 March 70 call at 5. The strike price of 70 = an interest rate of 7%

The premium of 5 = 5 x 100 = $500

If rates were to go to 8% by expiration the investor would have a $500 profit

80

-70

10

The 7% call option would be 10 points in the money at expiration and the investor’s account would be credited $1,000. This is found by multiplying the in the money amount by the contract multiplier of 100. Because the investor paid $500 for the option, their profit would be $500.

                                    Rates Up                Rates Down         Settlement

 

Priced Based

Options

 

Buy Puts or

Sell Calls

 

Buy Calls or

Sell Puts

Underlying

Security is

Delivered

Rate Based

Options

Buy Calls or

Sell Puts

Buy Puts or

Sell Calls

 

In Cash

 

INDEX OPTIONS

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