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Interest Rate Options

Interest Rate Options. Kayla Sims. Interest Rate Options. An investment tool in which the payoff depends on the future level of interest rates Underlying asset is typically a Treasury bond Changes in interest rates:

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Interest Rate Options

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  1. Interest Rate Options Kayla Sims

  2. Interest Rate Options • An investment tool in which the payoff depends on the future level of interest rates • Underlying asset is typically a Treasury bond • Changes in interest rates: • Opportunity: investors can capitalize on their outlook on the changes in interest rates • Risk: interest rate moves can adversely affect the value of their investments

  3. Interest Rate Options, Cont. • Available on the short, medium, and long-term rates • Short-term: the 13-week Treasury Bill yield is the recognized benchmark • Auctioned weekly • Medium-term to long-term rate: • 5-year rate (auctioned monthly) • 10-year rate (auctioned every 3 months) • 30-year rate (auctioned every 6 months)

  4. Two Types of Contracts • Puts (right to sell) • A put buyer anticipates that interest rates will go up (bond prices will go down) • Calls (right to buy) • A call buyer anticipates that interest rates will go down (bond prices will go up)

  5. Comparing Interest Rate Options to Other Options • Main difference: • Based on interest rates and not on units of specific Treasury bills, notes or bonds. • Prices on Treasury obligations, like prices on all fixed-income securities, are inversely related to interest rates. • THAT IS • When interest rates increase, the price on outstanding securities fall. • When interest rates decrease, the price on outstanding securities rise.

  6. Example • Consider a Treasury bond held by an investor • Par value $1,000, payable at maturity • Coupon interest rate of 7% • Bond pays $70 a year in interest • What if interest rates rise to 10%? • Would only need to invest $700 to receive the same payout

  7. Quiz • Forecast: Falling interest rate on a 5-year Treasury note • Objective: To profit from the decline in 5-year interest rates • An investor would like to have the opportunity to profit if this forecast is correct. • What type of option should he purchase?

  8. Interest Rate Options Features and Advantages • Features • Cash settled • European-style exercise • Advantages • Limited risk for option buying • Leverage • Hedging

  9. THANK YOU!

  10. HAPPY BIRTHDAY, AMANDA!!!

  11. References • http://www.cboe.com/learncenter/pdf/iro.pdf

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