Money Tips Network

Under the interest-rate option, which is in some ways a refinement of the forward-rate agreement, an option buyer purchases the right (but not the obligation) to lend or borrow at a guaranteed interest rate. In return the option seller receives a payment known as a premium, generally paid at the time the option is sold. On the day the option expires it is up to the option buyer to exercise the option and to lend or borrow it at the guaranteed rate if it is possible to do so. However, if the option buyer can achieve a better rate of borrowing or lending in the money markets, he or she will let the option lapse. The maximum loss to the option buyer is therefore the cost of the premium. The size of that premium depends on three factors: the relationship between the interest rate guaranteed under the option and the interest rate in the money markets; the time left before the option is due to expire; and the option seller’s assessment of whether interest rates are likely to move quickly.

If, for example, a company wanted to buy an option to borrow at 8 per cent at a time when interest rates were 10 per cent, there would be automatic potential for profiting from the option. As a result, the premium for the option would be at least 2 per cent and would be much larger than the premium for an option to borrow at 12 per cent in the same circumstances. An option to lend at, say, 12 per cent when interest rates were 10 per cent would carry a large premium, however, since it would have built-in profit potential.

Options which run for longer periods will also carry larger premiums. This is because the probability is greater that, over a long period, rates will move in such a way that the option will become more profitable to exercise. The option seller will charge a larger premium to reflect this extra risk.

How quickly interest rates will move is the hardest of the three elements for the option seller to assess. If the rate has shown a tendency to fluctuate violently in the past, it will obviously carry a higher premium than a rate which has shown a tendency to be stable.

An example will help to clarify the point. A company buys a three-month option to borrow at 10 per cent for three months, based on a nominal principal sum of ?1 million. At the time the option is sold, interest rates are 10 per cent and the option seller charges a premium of 1 per cent (?2,500).

Outcome 1 At the end of the three-month period interest rates are 12 per cent. The company exercises the option, thus borrowing at a rate of 2 per cent cheaper than if it had not bought the option (this is equivalent to a saving of ?5,000). However, the premium cost 1 per cent (?2,500), and the savings that the company makes (compared with its borrowing costs if it had not bought the option) are ?2,500.

Outcome 2 At the end of the three-month period interest rates are 8 per cent. The company lets the option lapse but is free to borrow at the cheaper rate available. Its extra costs are ?2,500, the cost of the premium, but its borrowing costs are less than it might have expected at the time when it bought the option.