An interest rate option is the right but not an obligation to exercise option at an agreed interest rate at maturity date.
Agreed interest rate is technically known as strike price.
Interest rate option is flexible in that holder of the option will exercise if exercising an option will prevent losses from interest rate movement. If option is not exercised until maturity, then it will automatically lapse. It means it cannot be exercised anymore.
In case of borrowings, organization should purchase call option (right to lend). In case of investment, organization will purchase put option (right to borrow).
Increase in interest expense will be offset by the increase in interest income and decrease in interest expense will be offset by the decrease in interest income. This way organization will be protected from interest rate movement in any case.
In case of borrowings, holder of the option will exercise, if market interest rate is higher than agreed interest rate. Holder of option will receive the difference (market rate – agreed rate) due to gain on exercising option. It will bring the interest rate to agreed rate (market rate – loss). Holder of the option will allow it to lapse, if market interest rate is lower than agreed interest rate. In this way, organization will be prevented from higher interest rate risk and it will not incur loss, if market interest rates are lower than agreed rate.
In case of investments, holder of the option will exercise, if market interest rate is lower than agreed interest rate. Holder of option will receive (market rate – agreed rate) due to gain on exercising option. It will bring the interest rate to agreed interest rate (market rate + gain). Holder of option will allow it to lapse if market interest rate is higher than agreed interest rate. In this way, organization will be prevented from lower market interest rate risk and it will not incur loss, if market interest rates are higher than agreed rate.
Cost of buying option is premium payable in advance at the time of agreement. Premium can be of significant value such as 10% of capital. Options are not derivative product, as they require significant cash outflow at the time of purchase.
Options can be used to hedge short term as well as long-term interest rate risk.
Organization that sells (call or put) option is known as option writer.
If option is worthwhile to exercise, then option is said “in the money”. If option is not worthwhile to exercise, then option is said “out of the money”.
Cost of purchasing option can be reduced in following ways
