Interest Rate Call Option

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21 Aug, 2024

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An interest rate call option is a financial derivative instrument that provides the right, but not the obligation, to the holder to earn a variable interest rate and offer a fixed interest rate on a specified principal amount for a certain period. The underlying securities usually involve interest rate derivatives.

On execution of such an option, the holder is liable to receive payment from the seller. Moreover, these are commonly used by banks and other financial institutions to lock the borrowers' interest rates. It even facilitates institutional investors and other market participants to manage interest rate risk and speculate on future interest rate movements.

What is the Interest Rate Call Option?

An interest rate call option is a financial instrument whereby the holder is not obligated but holds the right to avail a variable interest rate while offering a fixed interest rate on interest-bearing securities within a specific period.
The investor needs to pay a premium for buying a call option, and if the option is not exercised within the specified period, the holder loses the premium paid.
It is a common strategy lending entities adopt for locking the interest rates for borrowers. Also, it helps in hedging the interest rate risk and making speculative gains on floating interest rates.

Interest Rate Call Option Explained

An interest rate call option is like a special agreement where the owner can benefit if interest rates go up, but they're not obligated to do so. These options may cost more than other types, but the higher premium can be recovered with a profit when the option is exercised at a price significantly above its strike price.

This makes them valuable tools for market players looking to hedge against unfavorable interest rate changes or for investors and traders aiming to capitalize on expected interest rate increases upon the option's expiration. Traders often use these options to make informed bets on future interest rate changes, whether due to an anticipated economic recession or inflation.

The interest rate options’ future valuations are predictable using mathematical models like the binomial interest rate tree. All the interest rate options are exercised through cash settlement. Acknowledging that any form of options trading involves risks and complexities is essential. Thus, the investors should determine their risk tolerance level and investment objective while seeking a good understanding of the market and option pricing dynamics before engaging in such transactions.

It is possible to explain the concept with the help of a graph, as shown below. In the graph below, for instance, if an investor holds an interest rate call option whose strike price is 2% and the underlying asset is a treasury bill. Now, if the market rate increases to 2.5%, the option holder can exercise the option and get 2.5% while paying just 2% for the same. Thus, this happens due to the method in which the debt market functions. A rise in interest rate will lead to a fall in price and vice versa. Investors will try to protect their investments against risk and earn profits in the process. For that purpose, the interest rate call option offers an excellent way to do it.

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Examples

Let us look into some examples:

Example #1

Imagine John is a homeowner with a fixed-rate mortgage. He is concerned that interest rates may rise, causing his monthly mortgage payments to increase. To protect himself, he purchases an interest-rate call option. He buys a call option on interest rates with a strike price of 4%.

His mortgage rate is fixed at 3.5%. If interest rates rise above 4%, he can exercise the option. This means he has the right to refinance his mortgage at the lower fixed rate of 4%, even though market rates are higher. This helps him save money on his monthly payments, hedging against rising interest rates.

Example #2

Imagine Sarah, an investor, holds a 5-year corporate bond with a fixed interest rate of 3%. She worries that market interest rates might increase before her bond matures, potentially lowering its value. To safeguard her investment, Sarah buys an interest-rate call option. This option has a strike price of 3.5% on his 5-year bond, and she pays a premium for it.

In the following year, market interest rates did rise to 4%. Because Sarah owns the call option, she can use it to sell her bond at the higher market rate of 4% instead of the lower 3% rate, preserving the value of her bond investment and allowing her to sell it at a better price. This way, Sarah protects her investment from the impact of rising interest rates.

Benefits

An interest rate call option offers the following advantages to the investors and market participants:

Hedging against rising interest rates: By purchasing it, investors gain the right, but not the obligation, to buy an underlying financial instrument such as a bond at the strike rate within a specific time frame. If interest rates rise, the call option can be exercised, allowing the investor to secure the lower interest rate specified in the option contract.
Gains on falling bond prices: Decreasing bond prices means increasing interest rates. If the bond's market price drops below the strike rate specified in the option contract, the holder can purchase the bond at the lower market price and then sell it at the higher strike rate, making a profit.
Flexibility: As the investors don't have any obligation to exercise the option, they can decide whether to exercise the option based on the market conditions and analysis.
Limited risk: Since the risk with options is limited to the premium the holder pays for the options contract, the investors usually don't have uncertain or hefty losses.
Leveraged returns: Such investment provides huge profit on the leveraged funds when the investors manage to closely speculate the future interest rates and, thus, control a larger underlying asset position.
Portfolio diversification: It adds a variety of securities to the investment portfolio so that the investors can diversify their risk exposure.

Risks

Interest rate call options carry various uncertainties that investors should consider before putting money in such derivatives. These risks include:

Failure to time the exercise of the options: This type has a small lifespan, and if they expire without being exercised, investors lose the premium paid for the option. Investors must consider the timing of their options carefully and align it with their market expectations.
False market predictions: An investor sometimes uses such a strategy without accurately assessing market conditions. Thus, they cannot exercise the option profitably, and the paid premium will be lost if the interest rates move in the opposite direction than the anticipated figures.
Volatility risks: Thus, higher volatility of the interest rates can result in wider bid-ask spreads and reduced liquidity for options, which may affect the ability to enter or exit positions at desired prices. Also, unexpected interest rate fluctuations can cause significant price swings in the underlying securities, impacting the call option's value.
Loss of premium: Purchasing an interest-rate call option requires premium payment, which upsurges the cost of the option. If the market goes against the investors' expectations, then this premium paid will account for their losses.
Leverage amplifies risks: While leverage can amplify potential profits, it also increases the chances of losses. If the market moves against the investor's position, the losses can exceed the premium paid for the option. Hence resulting in a significant financial loss.

Frequently Asked Questions (FAQs)

1. Why does the call option value increase with interest rates?

As the interest rate of an underlying security for an interest rate call option rises, the holder's profit from exercising such an option also increases. Therefore, the value of the respective call option increases proportionately to the rise in the interest rate. This makes interest rate call options valuable for investors seeking to capitalize on potential interest rate hikes and maximize their returns.

2. Who uses interest rate call options?

This type of option is suitable for market speculators looking to profit from decreasing bond prices and anticipating future interest rate increases. They are also favorable to investors seeking to hedge their positions against fluctuations in floating interest rates.

3. What's the difference between interest rate call and put options?

In an interest-rate call option, holders anticipate rising interest rates until the option's expiration. Also, allowing them to buy the derivative at a predetermined low price. Conversely, investors profit if interest rates fall in the short term in an interest-rate put option.