Interest Rate Floor

If you are placing money on deposit and want to guarantee an interest rare, you sell an FRA. Of course, if interest rates rise, the FRA will lose money and bring the net interest back to the figuremyou wanted to ne guaranteed.

If you ever want to protect against downside only, but want to take advantage of upside, options kust be involved. This is true for both interest rates and exchange rates.

An interest rate floor protects against downside movements in interest rates, so we need a way of making use of protection if we need to. So instead of seling an FRA just take an option to sell the FRA should the need arise. An option to sell is a Put option.

IRGs using interest rate options behave differently. Remember, if an interest rate falls the option price will rise necause option price is 100-interest rate. This can be used to reduce risk because the interest rate loss/gain is offset by the option/gain loss

If we deposit money, we fear an interest rate fall. If that happened the price of the interest option would rise. To make a profit on options to compensate for the interest rate fall, we need to buy the option now (low price) and sell later (high price). If interest rates rose we would make a loss on the options. So, to protect against interest rate falls only, we want to have the right to buy at the current low price ie buy a call option on the interest rate future.

Interest rate guarantees are not achieved by selling options, whether put or call. The only time you normally encounter selling an option is to create a collar where you might buy a put and sell a call.