What is an 'Interest Rate Options'

An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. It is similar to an equity option and can be either a put or a call. Typically, the movement follows an underlying benchmark rate, such as the yield on the 10-year Treasury Note.

BREAKING DOWN 'Interest Rate Options'

As with equity options, an interest rate call gives the holder the right, but not the obligation, to benefit from rising interest rates. An interest rate put gives the holder the right, but not the obligation, to benefit from falling interest rates. Aside from outright speculation on the direction of interest rates, their main purpose is to allow portfolio managers and other institutions to manage risk across the domestic dollar-denominated yield curve.

Interest rate options trade formally through the CME Group, one of the largest futures and options exchanges in the world. Regulation of these options is handled by the Securities and Exchange Commission (SEC). An investor may use options on Treasury bonds and notes, and Eurodollar futures.

Interest rate options have European-style exercise provisions. This provision means the holder can only exercise their options at expiration. The limitation of option exercise simplifies their usage as it eliminates the risk of early buying or selling of the option contract. The rate option strike values are yields, not units of price, and are cash-settled. Also, no actual delivery of securities is involved. Payoffs are calculated from the value of the difference between the strike price, in percentage terms, and the yield on the underlying security, also in percentage terms.

Interest Rate Option Example

Interest Rate Options are similar to other options types in that they consider volatility, time to expiration, and the price (or yield in this case) of the underlying security. As with equity options, the cost of a contract is $100 times the strike before commissions.
 
At options expiration, a 10-year Treasury call trading in the money would have a positive value. If the strike is 2.25% and the yield on the underlying is 2.85%, the difference is 0.60. The investor will multiply the difference (0.60) by $100 to get $60 value per contract. Subtract the premium paid and the result is the net profit.

For an option that expires out of the money, its value would be zero, and the buyer of the option loses the entire premium paid.

As with other options, the holder does not have to wait until expiration to close the position. All the holder needs to do is sell the option back in the open market. For an options seller, closing the position before expiration requires the purchase of an equivalent option with the same strike and expiration.

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