Series 7: 5.5.3. Interest Rate Options

5.5.3. Interest Rate Options

When you buy a bond at a fixed interest rate, you are taking interest rate risk. As interest rates go up over time, the market value of a bond goes down. As interest rates go down, the price of the bond goes up. A bondholder can hedge the forward risk of rising interest rates by buying an interest rate call option. If the interest rate rises, you can exercise the call option. The money you receive from the differential between the current interest rate and the strike price will offset the losses on the sale of your bond.

An interest rate option is known as a yield-based option because its underlying asset is not a bond or some other asset, but an interest rate. An interest rate option provides the option holder with the right to buy or sell a fixed interest rate on or before some defined expiration date. Options may be bought and sold on short-term interest rates (e.g., 13-week Treasury bills) or on medium- and long-term rates (5- and 10-year Treasury notes and 30-year Treasury bonds). The option does not offer the rights to a bond, but to the interest rate it carries.

Interest rate calls and puts are generally traded on the Chicago Board Options Exchange. Over-the-counter interest rate options may also be bought and sold, often by portfolio managers. OTC option