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In the technical article at acca website there’s an example in which it is explained that interest rate options (exchange traded) buy the right for interest rate futures. If i have to borrow money after three months and current rate is 5% i.e futures are trading 95 so i’ll buy an option to sell futures at 95 in the future. Now after three months if the rate is 7%, i will exercise my option and sell futures at 95 and immediately buy back futures at current proce which is 93.
But initially i thought that by buying interest rate option we are directly buying the right to borrow money at a fix rate of interest. Is that so?
I’m confused bw these two options.. Please draw some light on it. ThanksOTC options are buying directly the right to borrow money at a fixed rate of interest.
However traded options are the right to buy (or sell) futures at a fixed price. If borrowing money then you will buy an option to sell futures. As the actual interest rate increases, the futures price will fall, and therefore you would exercise the option. Exercising it will mean buying the futures at the price on that date and immediately selling them at the exercise price – the resulting gain will ‘cancel’ out the extra interest payable on the loan.
Both OTC options and traded options are explained in my free lectures.
However appreciate that you cannot be asked any calculations on them in Paper FM. If you are interested and wish to see how the arithmetic works, then I explain with examples in the lectures for Paper AFM (where calculations are asked).
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