Interest Rate Cap
Interest Rate Caps are designed to provide insurance against rising interest rates by payment of a premium to the other party, who promises to make interest payments on specified future dates based on the excess, if any, of interest rates above a certain specified rate.
Interest Rate Floor
Interest Rate Floor is opposite of an interest rate cap agreement. It refers to the purchase of insurance against falling interest rates by payment of a premium to another party who promises to make a payment if a specified floating rate falls below a specified floor rate.
Interest Rate Collar
Collars are the combined purchase and sale of an interest rate cap and an interest rate floor so as to keep interest rate exposure within a defined range. One party agrees to make interest payments to the other party if interest rates exceed a certain rate (i.e. "sells" a cap) and the other party agrees to make interest payments if interest rates drop below a certain rate (i.e. "sells" a floor).
Interest Rate Swaption
Swaptions are options on forward-starting interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap at a specific date in the future, at a particular fixed rate (the strike rate), and for a specified term. The option is called a receiver swaption if the buyer has the right to receive fixed interest in the swap, and is called a payer swaption if the buyer has the right to pay fixed and receive floating interest in the swap.
Call/Put options on bonds/interest rates
A bond call/put option is an option to buy or sell a bond for a certain price on a certain date. In an interest rate call/put option, the underlying is a floating interest rate.
Interest Rate Futures
Interest rate futures are forward contracts on a benchmark interest rate traded on a stock exchange. A typical example is the futures contract on 3-month sterling Libor traded on the London International Futures & Options Exchange (LIFFE), which is known as a short sterling future.
Option Styles
American. "American" means a style of Option Transaction pursuant to which the right or rights granted are exercisable during an Exercise Period that consists of a period of days.
Bermuda. "Bermuda" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only during an Exercise Period which consists of a number of specified dates.
European. "European" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only on the Expiration Data.
European Swaption: Illustration
Suppose a corporate has a rupee liability maturing in the next three months. The corporate Treasurer is confident of funding this liability through an issue of 5-year paper around the same time. But the Treasurer wants to hedge the rate of this debt placement now. This rate would be composed of the “Treasury” rate and a “corporate spread” representing the credit risk charge. Suppose for the moment, that the corporate wants to hedge the “Treasury” risk only. Once options are permitted, the corporate could hedge the downside risk of rates moving sharply higher by buying a payer’s swaption on 5-year G-Sec rates expiring in 3 months. This product is nothing but a European swaption.
Barrier Option
An option, which is only exercised when the underlying item reaches a predetermined price.
Digital Option
These options are only exercised when the underlying item reaches a pre-determined price and then only pay a fixed amount regardless of how far in-the-money the option settles.
Index Amortizing caps, floors
A cap, floor with a notional principal amount that declines as a function of a short term money rate such as Libor. The use of an index protects the client from unanticipated or erratic prepayment risks.
Efficacy of Short Sales – An Illustration
Suppose that a bank offers an option, expiring in 3 months time, on a 5-year swap to a client (having a floating rate liability) where the client has the right to receive the prevailing one year government security yield from the bank on every interest payment date (say, annual) and pay a fixed rate, say, 6% on those dates for a certain notional principal. Also suppose a case where this is the only transaction outstanding in the bank’s books. Assuming that the “delta” of this swap is, say, 50%, i.e., the bank needs to hedge 50% of the notional amount of the 5-year received risk immediately. The ideal way, perhaps, would be to short the 5-year G-sec. However, the current regulations do not allow short selling. Therefore, the bank has to find some other way to pay the 5-year fixed rate, which may be done by looking for a counterparty that may want to hedge a fixed rate liability and hence receive a fixed rate from the bank. Alternatively, the bank may decide to hedge by selling some securities in the discretionary portfolio of similar duration to hedge the swap. But this portfolio approach of hedging is fraught with different kind of risks, particularly “basis risks” as “like for like” hedging is not achieved.
