Interest rate option
An interest rate option can protect against an adverse movement while retaining some benefit from a favourable one. Its payoff and exercise terms depend on the contract: an over-the-counter interest rate guarantee or cap may settle by reference to a rate, while an exchange-traded option may relate to an interest rate futures contract. A purchased option normally costs a premium. A hedge's total outcome includes the underlying borrowing or deposit, option settlement, premium, timing and any basis or counterparty risk. It is not identical to an obligation under a forward rate agreement.
Worked example
A borrower pays a premium for protection above a 6% reference rate on a $1 million six-month exposure. If the reference rate becomes 8%, a simplified settlement at period end is (8% − 6%) × $1 million × 6/12 = $10,000. Actual settlement may be discounted and uses the contract's conventions; include the premium separately.
Common mistake
Treating the option as a free guarantee or assuming that an option on a futures contract settles identically to a cash-settled over-the-counter rate guarantee.
Where it appears in your exams
| Qualification | Exam | Relationship | Period |
|---|---|---|---|
| ACCA | AFM | Direct | September 2026–June 2027 |
| ACCA | FM | Supporting | September 2026–June 2027 |