Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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Interest rate options are derivatives that let traders speculate on or hedge against interest rate fluctuations. These contracts are tied to benchmarks like U.S. Treasuries or Eurodollars, and are primarily used by institutions that manage rate exposure. These options are structured as calls and puts, and can be used to express a view on how yields might change over time.
This guide breaks down how interest rate options work, including key terms, common use cases, and the potential risks involved.
Key Points
• Interest rate options are financial instruments for speculating on or hedging against interest rate movements.
• These options are structured as calls and puts, linked to benchmarks such as U.S. Treasuries.
• Buyers of calls may potentially profit when interest rates rise, while the buyers of puts may benefit from falling rates.
• Interest rate options are settled in cash, with the maximum loss for the buyer limited to the premium paid.
• Trading these options involves significant market and interest rate risks, especially if the buyer misjudges rate direction, timing, or volatility.
What Are Interest Rate Options?
Interest rate options enable investors to hedge, speculate on, or otherwise help manage their exposure to interest rates. These financial derivatives are available as both puts and calls, and are traded on major options exchanges. They can also be used to secure exposure to a specific interest rate level over a set time frame. Interest rate options offer buyers the right to profit from a known rate level at expiration, often as a hedge against rising or falling yields. This cap may help secure more predictable outcomes in a volatile rate environment.
Interest rates in the U.S. fluctuate continuously, with the Federal Reserve being a key driver, among other factors. To mitigate the risk that interest rate fluctuations could erode portfolio value, and to potentially benefit from rate changes, professional money managers turn to interest rate options as a source for managing exposure.
Interest rate options are sold on major options exchanges as standardized puts and calls — the two primary types of option contracts. Similar to puts and calls on equity securities, interest rate options represent directional bets on the value of an underlying asset.
The value of interest rate options is tied to yields on interest-rate-linked assets, typically Eurodollars and U.S. Treasuries of various maturities. These options are cash-settled and typically do not involve the delivery of a bond. Instead, buyers receive a payout if the reference rate moves in their favor.
Buyers of interest rate options can gain exposure to a specific interest rate over a defined term. Treasury maturities are standardized terms commonly sold on the CME Group exchanges. These products are used primarily by institutional investors and sophisticated traders managing large portfolios or interest rate exposure. Professional money managers may use puts or calls at any given maturity to express their views on future rate movements or the volatility of borrowing costs over time.
For example, a fund manager concerned about rising borrowing costs could purchase a call option tied to the 5-year Treasury as a hedge. If rates rise, the option gains value. This could potentially offset higher financing expenses or losses elsewhere in the manager’s portfolio.
How Interest Rate Options Work
Interest rate options afford the buyer the right to receive payment based on the spread between the yield of the underlying security on the expiration date and the original strike rate of the option, net of fees.
Interest rate options in the United States feature “European-style” options exercise terms, which means they can only be exercised on the expiration date.
This contrasts with equity options, which more often contain “American-style” exercise terms. That means they can be exercised at any time before and on the expiration date.
Buyers of interest rate options pay a premium — the price of the options contract — to acquire the right to receive a cash settlement if interest rates move in their favor. Options pricing can be complex, and to profit on a trade, the buyer needs interest rates to move in their favor enough to cover the cost of the option’s premium.
In the event that interest rates don’t move in the option holder’s favor enough to overcome the strike rate, the option will expire worthless, and the option holder incurs the total loss of their premium.
We’ll cover how this dynamic plays out with respect to both interest rate calls and puts.
How Do Interest Rate Call Options Work
Buyers of interest rate call options seek to benefit from rising interest rates. Should the yield on the underlying security close above its strike rate on the expiration date, the owner of an interest rate call option will receive a cash payout. This payout will be the difference between the option value at maturity and its strike.
Note that interest rate options are cash-settled. Unlike equity options, no exercise is required. If the rate is higher than the strike rate, the holder is paid the difference.
Interest rate call options, much like equity call options, give the buyer potential upside exposure to rising yields. They can also offer a way to effectively “lock in” an interest rate level for potential payout calculation, which benefits the buyer if rates rise above the strike.
Holders of interest rate call options bear the risk that the option might expire out-of-the-money should interest rates remain beneath the strike by the expiration date. In this case, the maximum loss the owner of an interest rate call option can expect is limited to the premium paid.
How Do Interest Rate Put Options Work
In contrast, buyers of interest rate put options seek to benefit from falling interest rates. Interest rate puts give the put holder the right to receive payment based on the difference between the strike rate and the yield on the underlying security at expiration. Since the payout depends on the yield falling below the strike rate, the buyer effectively locks in the right to receive a higher interest rate (rather than pay a lower one) for a fixed period, compared to market rates at expiration. In this case, the strike rate is typically the maximum gain that a put holder may receive.
Holders of interest rate put options bear the risk that the put option might expire worthless (out-of-the-money) if interest rates rise above the strike by the expiration date. In this case, the maximum loss the buyer of an interest rate put option will incur is limited to the premium paid.
What Are the Risks of Trading Interest Rate Options?
Trading interest rate options may involve significant risk, particularly for any trader who either, 1) lacks understanding of the basic drivers of options valuation and interest rates, or 2) doesn’t know how to structure their options trade properly to manage risk exposure. The leverage associated with options trades can result in significant losses if not managed carefully. Since these contracts define a rate level at the outset, traders risk loss if actual market rates move unexpectedly in the opposite direction.
Traders must manage a range of key risks and may want to consider different strategies for trading options, when it comes to buying interest rate puts and calls. Risks related to interest rate options include “market risk,” or the risk of price movements driven by macroeconomic factors that affect financial markets. It also includes “interest rate risk,” or the possibility that changes in interest rates could erode the value of fixed-income holdings, especially when those shifts are abrupt or unexpected. Traders may also face losses if they misjudge rate direction, timing, volatility, or fail to anticipate how quickly investors might adjust their outlook based on new interest rate information.
Interest Rate Option Example
For example, an investor seeking to hedge their portfolio against rising interest rates may choose to buy an interest rate call option on a 10-year Treasury bond, expiring in two months at a strike of $50.00.
Strikes on interest rate options reflect a rate that’s multiplied by 10 and expressed in dollar terms to standardize pricing. Therefore a 5.0% rate converts to a strike price of $50.
If the option’s premium is quoted at $0.50, then buying a single interest rate call option would cost the buyer a $50 total premium, as each interest rate option affords the buyer exposure to 100 shares of the underlying interest rate.
If yields rise for the next 2 months until the option expires, the underlying might be worth $55 by the time it’s exercised.
In this instance, you can calculate your net profit using the following equation:
(Reference Rate at Expiry – Strike Rate) x 100 – Premium Paid = Profit
($55 – $50) X 100 ) – $50 = Profit
$5 X 100 – $50 = Profit
$500 – $50 = $450 Net Profit
Remember that each option contract grants exposure to 100 units of the underlying interest rate, while options premiums are quoted for a single unit of the underlying. Remember also to use the full contract premium and apply a multiplier of 100 when calculating net profit.
The Takeaway
Interest rate options may appeal to investors who understand the underlying drivers of these securities. They provide direct exposure to interest rates, on a leveraged basis, at a relatively competitive cost.
When employed strategically, interest rate options may allow investors to profit from changes in interest rates or help mitigate their downside in a volatile rate environment.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What are interest rate future options?
Interest rate future options are futures contracts tied to an underlying interest-bearing security. The buyer purchases the right to receive the interest rate payment in the contract, while the seller agrees to pay it.
These options allow both parties to lock in the price on an interest-bearing security, for future delivery, which offers both parties some level of price certainty within a specific timeframe.
What is an interest rate swaption?
Interest rate swaptions represent the right, but not the obligation, to enter into an interest rate swap on an agreed-upon date.
In exchange for the contract premium, the buyer of an interest rate swaption can choose whether to be a fixed-rate payer (payer swaption), or fixed-rate receiver (receiver swaption) on the underlying swap, with the counterparty taking the variable rate side of the transaction.
Unlike standard interest rate options, swaptions are over-the-counter products, allowing for more customized terms across expiration, exercise style, and notional amount.
What is interest rate risk?
Interest rate risk is the exposure of an investment to fluctuations in prevailing rates. Rates can change daily, based on economic growth, monetary policies set by central banks, or investor sentiment.
If interest rates rise, that shift may reduce the value of bonds and other fixed-income assets. Conversely, if rates fall, the value of outstanding fixed-income securities often rises. This kind of exposure defines interest rate risk.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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