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Interest Rate Options:
These are such derivative contracts where the holder of Interest Rate Options has a right but no obligation for borrowing or investing money at a pre decided interest rate.
For example, X Ltd. has been given an option by HDFC Bank to borrow $ 20,00,000 after 6 months for a period of 3 years at 12% per annum irrespective of prevailing interest rate.
In the above example, X Ltd. has a right and not an obligation to borrow after 6 months at 12% per annum. X td. Is holder of such Interest Rate Option and would have definitely paid premium for such option. X Ltd. will exercise this option only when such option is In-the-Money.
An Interest Rate Option is considered In-the-Money (in case of borrowing) when the prevailing interest rate in the open market is higher than the interest rate as per the option.
Caps, Floors and Collars:
X Ltd. is offered by its bank an interest rate option, according to which X Ltd. can borrow at its choice a sum of $ 1,00,000 after 1 year at 12% p.a.
After 1 year if prevailing interest rate for borrowing is higher than 12% p.a., X Ltd. will exercise this option of interest rate and will borrow at 12% p.a. irrespective of actual interest rate.
Y Ltd. is offered by its bank an interest rate option, according to which Y Ltd. can deposit at its choice a sum of $ 5,00,000 after 1 year at 8% p.a.
After 1 year if prevailing interest rate for deposit is lower than 8% p.a., Y Ltd. will exercise its option to make deposit at 8% p.a. irrespective of actual interest rate.
In the above given two examples, X Ltd. is willing to borrow and has risk of interest rates rising up. On the other side, Y Ltd. is willing to invest and has risk of interest rates declining.
Holding an interest rate option to borrow at a specified rate as given in case of X Ltd. as 12% p.a. provides protection to X Ltd. against upward movement of interest rate. Using such option, X Ltd. can borrow at prevailing interest rate or 12% p.a., whichever is lower. This option can fix an upper limit to interest rate. Such options are called “CAPS”.
Holding an interest rate option to invest at a specified rate at the option of the holder as given in case of Y Ltd. as 8% p.a. that protects the investor from downward movement of interest rate. Using such option, Y Ltd. can invest at prevailing interest rate or 8% p.a., whichever is higher. This option can fix a lower limit to interest rate. Such interest rate options are called “FLOORS”.
A combination of ‘CAP’ and ‘FLOOR’ can create a “COLLAR”.
The purchaser of a Collar buys a Cap and simultaneously sells a Floor. A Collar has the effect of locking its purchases into a floating rate of interest that is bounded on both high side and the low side.
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