Hedging Interest Rate Risk Using Interest rate option
Interest rate options allow businesses to protect themselves against adverse interest rate movements while allowing them to benefit from favourable movements. They are also known as interest rate guarantees. Options are like insurance policies:
- You pay a premium to take out the protection. This is non-returnable whether or not you make use of the protection.
- If interest rates move in an unfavourable direction you can call on the insurance.
- If interest rates move favourable you ignore the insurance.
Options are taken on interest rate futures contracts and they give the holder the right, but not the obligation, either to buy the futures or sell the futures at an agreed price at an agreed date.
Using options when borrowing
As explained above, if using simple futures contracts the business would sell futures now then buy later.
When using options, the borrower takes out an option to sell futures contracts at today’s price (or another agreed price). Let’s say that price is 95. An option to sell is known as a put option (think about putting something up for sale).
If interest rates rise the futures contract price will fall, let’s say to 93. Therefore the borrower will buy at 93 and will then choose to exercise the option by exercising their right to sell at 95. The gain on the options is used to offset the extra interest that has to be paid.
If interest rates fall the futures contract price will rise, let’s say to 97. Clearly, the borrower would not buy at 97 then exercise the option to sell at 95, so the option is allowed to lapse and the business will simply benefit from the lower interest rate.
Using options when depositing
As explained above, if using simple futures contracts the business would buy futures now and then sell later.
When using options, the investor takes out an option to buy futures contracts at today’s price (or another agreed price). Let’s say that price is 95. An option to buy is known as a call option.
If interest rates fall the futures contract price will rise, let’s say to 97. The investor would therefore sell at 97 then exercise the option to buy at 95. The gain on the options is used to offset the lower interest that has been earned.
If interest rates rise the futures contract price will fall, let’s say to 93. Clearly, the investor would not sell futures at 93 and exercise the option by insisting on their right to sell at 95. The option is allowed to lapse and the investor enjoys extra income form the higher interest rate.
Options therefore give borrowers and lenders a way of guaranteeing minimum income or maximum costs whilst leaving the door open to the possibility of higher income or lower costs. These ‘heads I win, tails you lose’ benefits have to be paid for and a non-returnable premium has to be paid up front to acquire the options.
Source: Ken Garrett, ACCA