Hedging Interest Rate Risk with Options

The use of options to hedge against interest rate risk is a very common practice, and there are a variety of options available to serve this purpose. Some are futures options like the ones we have been discussing, and these trade on organized exchanges. For example, we mentioned the Treasury bond contract in our discussion of futures. There are options available on this contract and a number of other financial futures as well. Beyond this, there is a thriving over-the-counter market in interest rate options. We will describe some of these options in this section.

A Preliminary Note Some interest rate options are actually options on interest-bearing assets such as bonds (or on futures contracts for bonds). Most of the options that are traded on exchanges fall into this category. As we will discuss in a moment, some others are actually options on interest rates. The distinction is important if we are thinking about using one type or the other to hedge. To illustrate, suppose we want to protect ourselves against an increase in interest rates using options; what should we do?

We need to buy an option that increases in value as interest rates go up. One thing we can do is buy a put option on a bond. Why a put? Remember that when interest rates go up, bond values go down, so one way to hedge against interest rate increases is to buy put options on bonds. The other way to hedge is to buy a call option on interest rates. We discuss this alternative in more detail in the next section.

We actually saw interest rate options in Chapter 7 when we discussed the call feature on a bond. Remember that the call provision gives the issuer the right to buy back the bond at a set price, known as the call price. What happens is that if interest rates fall, the bond's price will rise. If it rises above the call price, the buyer will exercise its option and acquire the bond at a bargain price. The call provision can thus be viewed as either a call option on a bond or a put option on interest rates.

Interest Rate Caps An interest rate cap is a call option on an interest rate. Suppose a firm has a floating-rate loan. It is concerned that interest rates will rise sharply and the firm will experience financial distress because of the increased loan payment. To guard against this, the firm can purchase an interest rate cap from a bank (there are banks that specialize in such products). What will happen is that if the loan payment ever rises above an agreed-upon limit (the "ceiling"), the bank will pay the difference between the actual payment and the ceiling to the firm in cash.

A floor is a put option on an interest rate. If a firm buys a cap and sells a floor, the result is a collar. By selling the put and buying the call, the firm protects itself against

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

23. Risk Management: An Introduction to Financial Engineering

© The McGraw-Hill Companies, 2002

CHAPTER 23 Risk Management: An Introduction to Financial Engineering increases in interest rates beyond the ceiling by the cap. However, if interest rates drop below the floor, the put will be exercised against the firm. The result is that the rate the firm pays will not drop below the floor rate. In other words, the rate the firm pays will always be between the floor and the ceiling.

Other Interest Rate Options We will close out our chapter by briefly mentioning two relatively new types of interest rate options. Suppose a firm has a floating-rate loan. The firm is comfortable with its floating-rate loan, but it would like to have the right to convert it to a fixed-rate loan in the future.

What can the firm do? What it wants is the right, but not the obligation, to swap its floating-rate loan for a fixed-rate loan. In other words, the firm needs to buy an option on a swap. Swap options exist, and they have the charming name swaptions.

We've seen that there are options on futures contracts and options on swap contracts, but what about options on options? Such options are called compound options. As we have just discussed, a cap is a call option on interest rates. Suppose a firm thinks that, depending on interest rates, it might like to buy a cap in the future. As you can probably guess, in this case, what the firm might want to do today is buy an option on a cap. Inevitably, it seems, an option on a cap is called a caption, and there is a large market for these instruments.

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