Interest Rate Options - A discussion of how investors can help control interest rate exposure and make the most of the interest rate market pdf

A yield-based call option holder will profit if,by expiration, the underlying interest rate risesabove the strike price plus the premium paidfor the call.. Conversely, a yield-based put

Interest Rate Options

A discussion of how investors can help control interest rate exposure and make the most of the interest rate market.

The Chicago Board Options Exchange(CBOE) is the world’s largest optionsmarketplace and one of the largestsecurities exchanges in the UnitedStates CBOE was founded in 1973,creating the world’s first standard-ized, listed equity options CBOE’ssuccess has been accomplished byleadership, innovation and itscommitment to individual andinstitutional investors worldwide.CBOE continues to push forwardwith new products and new tech-nology that help meet the needs ofthe investing community.

1-877-THE-CBOE

www.cboe.com

than interest rates.

Two of the most closely watched interest ratesare the benchmark rates on short-term and long-term U.S Treasury securities They reflect

changes in general economic conditions,

inflationary expectations, monetary and fiscalpolicies and the value of the U.S dollar Otherinterest rates, including bank prime lendingrates, home mortgage rates and corporate andmunicipal bond rates, tend to respond to trends

in the Treasury markets

For investors, fluctuations

in interest rates represent:

•Opportunity Investors can capitalize

on their outlook on these rates

•Risk Interest rate moves can

adversely affect the value of theirinvestments

With CBOE Interest Rate Options, aninvestor has a tool to help control interest rateexposure and take advantage of new investmentopportunities These options give investors thechance to invest based upon their views on thedirection of interest rates.

What are interest rate options?

Interest Rate Options are options on the spot yield of U.S Treasury securities Available tomeet the investor’s needs are options on short-,medium- and long-term rates The followingcontracts are available for trading at the ChicagoBoard Options Exchange:

• Options on the short-term rate (ticker

symbol IRX) are based on the annualized discount rate on the most recently auc- tioned 13-week Treasury bill The 13-weekT-bill yield is the recognized benchmark ofshort-term interest rates These bills are issued

by the U.S Treasury in auctions conductedweekly by the Federal Reserve Bank

• Options on the 5-year rate (ticker symbol

FVX) are based on the yield-to-maturity of the most recently auctioned 5-year Treasury note The notes are usually auctioned everymonth

• Options on the 10-year rate (ticker symbol

TNX) are based on the yield-to-maturity of the most recently auctioned 10-year Trea- sury note The notes are usually auctioned

every three months following the refundingcycle: February, May, August and November.

• Options on the 30-year rate (ticker symbol

TYX) are based on the yield-to-maturity of the most recently auctioned 30-year Trea- sury bond Treasury bonds are auctionedevery six months in a February and Augustrefunding cycle

IRX, FVX, TNX, and TYX values are reported

throughout the trading day by Telerate Systems

Incorporated, a leading international supplier of

financial services These values are based oncurrent market data from the Treasury securitiesmarkets Options prices, on the other hand, aredisseminated by CBOE Both these values andoption prices are available through most on-linepricing services

How do interest rate options work?

Options on interest rates and listed stock andstock index options have similar benefits andrisks They are standardized contracts traded on

an exchange regulated by the Securities andExchange Commission There are two types ofcontracts: puts and calls

In general, when yield-based option positions arepurchased, a call buyer and a put buyer haveopposite expectations about interest rate move-ments A call buyer anticipates interest rates will

go up, increasing the value of the call position A

put buyer anticipates that rates will go down,increasing the value of the put position

A yield-based call option holder will profit if,

by expiration, the underlying interest rate risesabove the strike price plus the premium paidfor the call

Conversely, a yield-based put option holder will

profit if, by expiration, the interest rate hasdeclined below the strike price less the premium.Option writers (sellers) receive a premium forselling options to buyers Sellers tend to viewpremiums received for selling options as a source

of additional income or as a hedge against apossible decline in the value of treasuries theyhold or intend to purchase

Yield-based options can be used alone or inconjunction with the underlying securities Theeconomics of the two approaches may be quitedifferent Prospective investors should consulttheir financial advisor about the logistics andsuitability of their approach

The Options’ Underlying Values

Underlying values for the option contracts are

10 times the underlying Treasury yields (rates)—

13-week T-bill yield (for IRX), 5-year T-noteyield (for FVX), 10-year T-note yield (for TNX)and 30-year T-bond yield (for TYX) Anannualized discount rate of 5.5% on the newlyauctioned 13-week Treasury bills would place theunderlying value for the option on short-termrates (IRX) at 55.00 A yield-to-maturity of 6%

Cash settled Interest Rate Options

are settled in cash There is no need

to own or deliver any Treasury

securities upon exercise

Contract size Interest Rate Optionsuse the same $100 multiplier asoptions on equities and stock

indexes

European-style exercise The holder

of the option can exercise the right

to buy or sell only at expiration Thiseliminates the risk of early exerciseand simplifies investment decisions

on the 30-year T-bond would place the

underlying value of the yield-based option onthe 30-year T-bond (TYX) at 60.00

When Treasury rates change, correspondingunderlying values for the options on interestrates also change For example, if the yield-to-maturity on the 30-year T-bond increases from6.25% to 6.36%, TYX would move from 62.50

to 63.60 For every one percentage point rise orfall in interest rates, underlying values would rise

or fall 10 points

Interest Rate Options features:

Comparing Interest Rate Options toother options.

A main difference between Interest Rate Optionsand listed equity options is that the underlyingvalues of Interest Rate Options are based oninterest rates and not on units of specific

Treasury bills, notes or bonds Individual equityoptions’ underlying securities are shares of aspecific stock

Prices on Treasury obligations, like prices on allfixed-income securities, are inversely related tointerest rates An investor must be able tounderstand this inverse relationship betweenbond prices and yields That is, whenever interestrates rise, prices on outstanding Treasury

securities fall Whenever interest rates decline,prices on outstanding Treasury securities rise

To see why prices must fall when interest ratesrise, consider a Treasury bond held by an

investor with a principal or par amount of

$1,000, payable at maturity, and a couponinterest rate of 7% This means that the bondpays $70 a year in interest until maturity, whenthe principal amount of $1,000 is paid tothe holder These terms will not change over thelife of the bond Like a stock, this bond has avalue for which it can be sold in the market.That value reflects the rate at which the market-place discounts this bond’s payment stream

If interest rates rise, the amount that would benecessary to invest to receive $70 per year woulddrop (If, for example, rates rise to 10%, thenecessary investment would be only $700.) Thefact that a smaller investment is required toreceive the same payment stream explains whybond values fall as long-term rates rise But theconverse is also true As long-term rates fall alarger investment is required to receive the samepayment.

There are formulas or algorithms that allowinvestors to find bond prices given knowledge oftheir yields or their yields given knowledge oftheir prices The actual calculations, however, arecomplex Desired numbers can be found usingspecialized calculators and bond tables Theymay also be available from your financial

advisor

Cash Settlement

Since Interest Rate Options are cash-settled,

exercise of a put or call gives the holder the cashdifference between the exercise price and theexercise-settlement value, times the $100

multiplier The exercise-settlement value is based

on the spot-yield, as reported by Gov Px

For example, an investor holding an expiring

TYX “ in-the-money ” (ITM) July 75 call option

with an exercise-settlement value of 78 would

exercise the option and receive the cash

difference of $300 [(78 - 75) x $100] Anoption is ITM if the underlying security ishigher (lower) than the strike price of the call(put)

option simply expires “ out-of-the-money ”

(OTM) and will be worthless If the

exercise-settlement value turned out to be at or below the

75 strike price at the July expiration, the TYXJuly 75 call option would be worthless

Of course, an investor does not have to waituntil expiration to close an option position A

closing transaction could be executed at anytimeprior to expiration For instance, an openingpurchase of the TYX July 75 call option could beclosed out by selling the same TYX July 75 calloption at anytime prior to the July expiration.The profit (or loss) in the position would be thedifference between the premium originally paidwhen the option was purchased and the pre-mium received upon the sale of the option

Interest Rate Movement

and Option Premium

Interest Rate Options in many ways are like allother traded options They are affected by

similar factors: e.g., volatility, time to expiration,and the price level of the under-lying instru-ment Nonetheless, there are certain consider-ations regarding the structure of interest ratesand the very nature of the underlying instru-ment itself that investors must take into account

to fully understand the behavior of interest rateoptions and their differences from other tradedoptions

Since these options will settle at a future

expiration date, investors must form tions about the yield on the underlying instru-ment The yield that the market expects to

expecta-prevail at expiration is called the forward yield

expiration of the options; or, in other words,the market’s best estimate of the exercise-settlement value at expiration, that is, off the

forward rates. If the market is currently

projecting a forward rate that is below thecurrent spot rate, call options will fall in valueand put options will rise in value

The forward pricing phenomenon may beapparent only at the short-end of the yieldcurve.

The difference between the current spot yieldand the forward yield can be significant, evenfor short-dated options In general, it willdepend on the segment of the U.S Treasury

yield curve considered In the U.S., the yieldcurve has been upward-sloping (normal) duringmost of modern U.S financial history, meaningthat long-term Treasuries have a higher yieldthan short-term A downward-sloping (inverted)

or flat yield curve illustrates short-term ies with a higher yield than long-term Thecurve has also been steeper at the short end with

Treasur-a tendency to flTreasur-atten out Treasur-at longer mTreasur-aturities Aconsequence of this type of yield curve is thatthe shorter the maturity of the Treasury securi-ties, the greater the divergence between currentspot and forward yields There is likely to be lessdifference between the yield of a Treasury bondwith 30 years to maturity and the yield of aTreasury bond with 29-3/4 years to maturitythan there is between the yield of a 13-weekT-Bill with 3 months to maturity and theyield of a 13-week T-Bill with one month tomaturity

Tracking Forward Rates

Again, call options have intrinsic value when

the current underlying value is greater thanthe exercise price Put options have intrinsic value when the current underlying value is

lower than the exercise price A result of

options tracking forward rates rather thancurrent spot rates is that when rates are

projected to fall, call options can trade belowintrinsic value relative to the current spotyield In other words, trading at a discountfrom parity can occur

The time value of an option is that part of thepremium that reflects the remaining life of theoption The more time that remains before theexpiration date, the higher the premium,

because there is more time available for theunderlying value to move up or down Anotherresult of forward pricing is that premiums may

be lower in the later months than in nearbymonths when the market is forecasting a lowerforward rate in the far month than in the nearbymonth If the difference in forward rates is large

enough to offset the time value associated withthe longer expiration, then the premium on thelonger expiration could be below the premium

on the nearby month with the same strike price

The same but reverse phenomenon appears inputs when the market is projecting higherforward rates relative to current interest rates.The time premium in the far out monthsmay be less than the near-term months due tothe market projecting a higher forward rate inthe far month than in the nearby month.Also, if the market revises its estimate of

forward rates, option prices may move sharplywhen current spot rates are unchanged

Option buying involves a known and limited risk. Like any option, the most an option buyercan lose if interest rates move against him is thepremium paid for the option Unlike a Treasurysecurity, however, an option can expire worth-less Option selling involves limited profit andunlimited risk Like any option, the most a sellercan make is the premium received and the risktheoretically is unlimited if interest rates moveagainst him.

Options provide leverage. An option buyerpays a relatively small premium in relation tothe value of the underlying security If interestrates move as anticipated, substantial profitsrelative to the capital invested may be realized

If the interest rates do not move as anticipated,the buyer’s risk is limited to the premiumpaid Also, small moves in interest rates canhave a large impact on the value of the optionsposition

Options involve a specific time period An

option buyer can choose an expiration monthwhich meets his time expectations for interestrates moves Treasury securities do not have tomove immediately for a buyer to profit on hisoption position However, a move in the

anticipated direction must occur by option expiration in order for the option position to become profitable.

In the following examples, we present a variety

of possible option strategies for different interestrate forecasts These are only a few of the

strategies that might be employed There arenumerous other strategies, some more sophisti-cated than others, that may be used by investorswho are experienced and understand how theywork and when to use them The examplesdiscussed below are based on hypothetical

situations, should only be considered samples ofpotential investment alternatives, and are

presented for educational purposes only

The positions are shown being held to tion It should also be noted that taxes,

expira-commissions and margin requirements havenot been included in the following examples

to simplify the explanations They are tant and must be taken into account whenconsidering an actual trade, and when calcu-lating actual net returns on any option

impor-transaction These charges and requirementsmay vary, and should be discussed with yourinvestment advisor

This strategy gives the buyer the right to a payoff equal to the difference between the strike price and exercise-settlement value of TYX upon option expiration if the underlying value rises above the strike price The profit is unlimited, while the risk

is limited to the premium paid for the calls.

Example:

TYX is at 70.00 (the 30-year interest rate at7.00%) and a three-month TYX 70 at-the-money call is trading at 1.50 For this

example, the investor who expects 30-yearTreasury yields to rise will buy 5 calls at a cost

of $750 (1.50 premium x $100 multiplier x 5

Buy TYX calls.

1

contracts) A profit will be realized if the

underlying rises above the breakeven of 71.50(70 strike price + 1.50 premium) which

translates into a current yield of 7.15%

(1/10th of the underlying value) on the 30-yearTreasury

Exercise-settlement Value: 75

Less Strike Price: 70

5Amount Paid to Holder: $2,500(5 x $100 x 5 contracts )

Less Cost of Calls: -750

This investor profited because the yield didrise above the breakeven prior to expiration.Had the yield on the 30-year Treasury risenafter expiration the options would have

expired worthless This timing considerationapplies to all of the strategies discussed below

Outcome 2:

Exercise-settlement Value BetweenCall Strike Price (70) and BreakevenLevel (71.50)

If, by expiration, the 30-year Treasury yieldslightly increases to 7.10% which equals anexercise-settlement value of 71.00, the holderwould exercise his options He would receivethe amount by which the exercise-settlementvalue is above the strike price The amountreceived would be less than what was origi-nally paid, but it would offset some of the cost

of the calls

Exercise-settlement Value: 71

Less Strike Price: 70

1Cost of Calls: $750Less Amount Paid to Holder: -500(1 x $100 x 5 contracts )

no matter how low interest rates decline themost that can be lost is the premium paid

Importantly, if the yield on the Treasury risessubstantially and/or the investor’s opinion

changes, the calls may be sold at any point intime through the last trading day of that

particular series

Forecast: Investor expects moderate rise

in 30-year Treasury bond yields

Objective: To profit from an increase

in rates by bringing in income

If a rise in the 30-year Treasury bond yield is expected, an investor may choose to sell a TYX put spread to increase income Selling a put spread involves selling a put and buying a put with a lower strike price, both with the same expiration The purpose in selling the put spread is to limit risk while receiving premium The most that can be lost

is the difference between the two strike prices less the premium received and the most that can be made is the premium received for selling the

spread If the investor simply sold puts outright he would have received more premium but with significant risk.

investor will sell 1 three-month TYX 75 putand purchase 1 three-month 70 put Thepremium received for this spread position is:

Sell 1 Three-month 75 Put

at 4.75 x 100 = $475.00*Buy 1 Three-month 70 Put

at 1.25 x 100 = -125.00Total Premium Received = $350.00

* These puts are trading at a discount to paritydue to the European-style exercise (theoptions cannot be exercised until expiration)

The total premium received is the maximumprofit that can be made The maximum risk isthe difference between the strikes less thepremium received

Short Strike: 75

Long Strike: -70

5Premium Received: -3.50

Maximum Risk: 1.50

The risk for this position is 1.50 x 100 or

$150.00 The breakeven on this position is71.50 The breakeven is calculated by sub-tracting the premium received, 3.50 from theshort 75 strike price

Possible Outcomes

Outcome 1:

Exercise-settlement Value At or

Above Short Put Strike Price (75)

If 30-year the Treasury bond yield rises and theexercise-settlement value for TYX is at 76.00 atexpiration (interest rates at 7.60%), the TYX 70put and the 75 put both expire worthless andthe investor keeps the total premium received,

$350.00 This is the maximum profit that could

be earned This would be the result for any TYX

exercise-settlement value at or above 75

be assigned on his short put position and hislong position would expire worthless He woulddeliver the amount by which the exercise-settlement value is below the strike price Theseller of the spread would give up some of thepremium received but not all of it

Short Strike Price: 75

Less Exercise-settlement Value: -74.5

Amount to Deliver: 5

Amount Rec’d for Selling Spread: $350.00Less Amount to Deliver: -50.00 (0.5 x $100 x 1 contract)

Profit: $300.00

Outcome 2:

Exercise-settlement Value BetweenLong Put Strike Price (70) andBreakeven (71.50)

If, at expiration, the yield on the TYX is7.05% (the exercise-settlement value is 70.5),the spread seller would be assigned on theshort side The seller would have to give backsome of the premium received

Short Strike Price: 75

Less Exercise-settlement Value: -70.5Amount to Deliver: 4.5

Amount to Deliver: $450.00(4.5 x $100 x 1 put)

Less Original Premium Received: -350.00

Outcome 3:

Exercise-settlement Value At orBelow Long Put Strike Price (70)

If the exercise-settlement value is at 67.5 (theyield on the 30-year Treasury is at 6.75%),the spread seller would have lost 1.50, thedifference between the strikes (5) less thepremium received for selling the spread(3.50) However, no matter how low interestrates decline, the most that can be lost is

$150.00, the difference between the strikesless the premium received

Short Strike Price: 75

Less Exercise-settlement Value: -67.5Amount to Deliver: 7.5

Long Strike Price: 70

Less Exercise-settlement Value: -67.5

Amount Received: 2.5

Amount Delivered: 7.5

Less Amount Received: -2.5

The spread seller would pay out $750 (7.5 x $100

x 1 put) for the assignment of his short put andwould receive $250 (2.5 x $100 x 1 put) forexercising his long put for a net cost of $500

Net Delivered (See Above): $500.00Less Original Premium Received: - 350.00Maximum Loss: $150.00

As the exercise-settlement value declines below 70the amount to be delivered will increase but sowill the amount paid to the investor The netamount will always be $500, the differencebetween the two strikes Therefore, the risk islimited to $150.00, the difference between thestrikes less the premium received for selling theput spread