- August 16, 2018 at 4:49 pm
Can you please help with a query on FRA’s?
I recently did tan exam practice question which was asking which of a list of statements were true about an Interest Rate Floor. One of the statements was that
‘an interest rate floor can be achieved by BUYING a PUT on an FRA’.
The answer stated that this was true.
I am a bit confused . All my notes and study text I have tell me that if you have a deposit then the following apply
FRA – If depositing you SELL an FRA (Put)
If borrowing you BUY an FRA (Call)
IRG – If depositing you would sell an FRA so need a PUT Option
If borrowing you would buy an FRA so need a CALL Option
So does this mean if you are taking out an IRG you BUY a PUT option or BUY a CALL option. Is it an IRG that they are refering to in the question.
Wheras with an FRA you either SELL an FRA or BUY an FRAAugust 16, 2018 at 6:49 pm
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.August 23, 2018 at 3:57 pm
Thank you. for your response
I think it is the terminology i am not getting with IRG’s
So for instance if I decided to hedge against an interest rate fall on a deposit and I wanted to use an IRG…. do I buy an IRG? The deeper I delve the more confused I am getting.August 23, 2018 at 4:45 pm
Sorry back to the IRG
If I was to use an IRG am I right in thinking that you do not actually buy an IRG but take out an option on an FRA. Is the term IRG just used to differentiate it as an over the counter option as opposed to exchange traded options.
So if i wanted to hedge against interest rate fall on a deposit – i would take out an OTC PUT option to buy an FRA
If I wanted to hedge against interest rate increase on a loan – I would take out an OTC CALL option to sell an FRA
To put this in very basic terms – when they say over the counter you picture in your head a person standing behind a counter(well that’s my simplistic thought pattern) So I approach this person with a view to protecting the interest rate on my future deposit and say ‘I would like to take out a PUT option to buy an FRA’ No mention of IRG???
Is that correct?August 23, 2018 at 11:24 pm
Don’t think in terms of buyimg an IRG, think in terms of arranging an IRG and this can be done by buying the appropriate options, put or call depending on whether the guarantee is for maximum or minimum interest rates, to limit the downside risk.August 24, 2018 at 12:51 pm
Thank you I understand that now
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