Interest Rate Options Strategies

Specific strategies for interest rate options

• Cap and floor

Although they are not, strictly speaking, options, caps and floors are usually stored in the same category. These products do indeed play the same role, namely an interest rate cap (cap) or floor (floor). They apply primarily to cash transactions.

The above examples are based on the covers of relatively short durations. Instruments for cash in the medium or long term, these strategies seem impractical, so were put in place contracts for Caps and Floors.

• The buyer of a cap is provided as a floating rate loan will not exceed a certain rate (cap rate).

• The buyer of a floor is assured that the floating rate loan will not fall below a certain rate (floor rate).

The floor or the ceiling rate are at an exercise price of the course or the floor.

The buyer of a cap or floor is, as in options, pay a premium. In return, the seller agrees to pay the buyer an interest rate differential between the exercise price and the market rate (usually a classic reference rate: Libor, Euribor, etc..).

An example may illustrate this:

• A client in need of cash over a period of 5 years wants to make a loan.
• To take advantage of a possible rate cut short, he wants to set up loans for 1 year renewable.
• The first loan is made 3.50%.

Fearing ** higher rates for subsequent periods, our client is establishing a cap of 3.75% (maximum rate).

If ** for the following periods, the rates actually go up, our client will receive the difference between the market rate at one year and the exercise price of course.

Of course the reasoning above applies equally to the purchase

a floor (guaranteed floor rate).

Specific strategies for options on interest rate swaps

• Swaption

For this product, the buyer has the right (always against payment of a premium to the seller) to pay or receive the fixed rate.

We distinguish the right to pay the fixed rate and receive variable-rate payer swaption, the right to receive fixed and pay variable-rate swaption recipient.

During the development of this product, we will define separately the characteristics of the option and swap the underlying rate.

• Type and amount of options

In France, swaptions are mainly European options which are exercisable only at maturity, usually representing amounts exceeding EUR 5 million. However, it is necessary to manage options such as some U.S. companies (large corporates) are brought into use.

• Reference Rate

The choice of the reference rate – actuarial or linear – is arbitrary: there is no market rules. However, note that swaptions are similar swaps.

• Reference Currency

The option and the underlying are generally denominated in the same currency.

• The duration of contracts

Swaptions are short-term products that focus on interest rate instruments in the long run. Thus, the right to exercise the option is usually over a period of 1 month to 1 year (most often 1 to 3 months), while the duration of the underlying swap from 2 to 10 years.

• The nature of “settlement

The fact of success on the implementation of the underlying swap (swap” settlement”) or the payment / receipt of a cash payment (” cash settlement”) is defined:

– Either at the conclusion of the swaption, operation date or value

– Either at the expiration of the option, ie at the time of exercise.

• The premium
  • The calculation of the premium

It serves as a listing on the option.

The premium payable is always flat ie it applies to the notional amount at a time when the contract or upon the expiration of the option. It represents the discounted future cash flows and is calculated as% of notional.

• The motto of the premium

The premium may well be paid or received in another currency. In this case, the brokerage must be denominated in the currency of the premium so that the net remains consistent.

• Options on swaps depreciable

Options on swaps to manage depreciable equally to non-depreciable swaptions with the difference that in the implementation of the swap if the option is exercised, the amount of interest received / given periodically be calculated from a notional every time decreased the amount amortized in the previous period.

• Options on currency swaps

Options on currency swaps are so negligible as they are complex to implement because of the need to construct two curves volatility during + rate) for each branch.

Procurement practices and opt for more “cancelable currency swaps” that grant the buyer a period allowing it to cancel the operation of underlying currency swap. This period of a duration of 1 to 3 months, represents an agreement between both parties and it is by no means optional. But again this market practice remains little used.

• The swaption premium reduced

There is now a form of swaption which reduces the immediate cost and often higher premium: for a limited risk-taking, this premium can be reduced by half or more. Thus, the swaption premium is reduced to a classic swaption which we added a condition on the evolution rate of the underlying swap, the idea being that this rate should not get a fork that has been fixed originally by the counterparties.

It is therefore a dual option limits because if this rate remains within the range determined for the duration of the option, the company will set up the swap guaranteed. If, against the reference rate outside the range, the swaption is automatically disabled and the rate guarantee disappears.

• Activating and deactivating barriers

Always in the context of reducing the premium to the commitment, it is possible to install barriers to fluctuations in line activation. Principle similar to barrier options, it would determine two ranges of fluctuation, the one guaranteeing a maximum increase of rates, the other ensuring maximum decrease.

Example: A buyer of a put swaption borrower guaranteeing a rate to 7.8% in six months, may deal in securities of fluctuations up from 7.8% to 8.5%, and the values of downward fluctuations of 6.5% to 7.7%. In this case, if by the due date of the option the rate reaches 8.55%, the swaption is disabled. If instead the rate drops to 6.5%, the swaption is activated at a rate of 6.5%.

Note: activating the barriers are interesting on swaptions periods longer than two years, with premiums amounting to 5 or 6%. They are more established with a view to cover.

• The outcome of the option

In practice, the exercise of the option gives rise to either the establishment of swap (swap settlement), or the payment of a cash payment (cash settlement) representing the value of the swap market at the date of exercise, this value being determined by the principle of valuing an interest rate swap (considering that valo date = date of exercise of the option).

The calculation method used to value the swap is arbitrary because no method prevails over another on the market.

Remarks:

1. The proportions of the market would be 40% of swap settlement against 60% of cash settlement.

2.In the event that the option is exercised, the change in the characteristics of the swap should be made impossible by the user because, determined at the time of the commitment of the swaption, they represent the contract terms.

• Reversal of position

In a speculative perspective, when the operator is a swaption seller, it may have to reverse its position if the market reference rate is close to the strike, to prevent the swaption is exercised.

The strategy is to buy back its position partially or completely depending on the risk involved in buying a new swaption an amount less than or identical with the same Caracteristics.

So that the purchases / sales due to reversals of positions are identified in relation to purchases / sales of single swaptions, it is essential to be able to bind to the initial operation.

• Termination / renegotiation

In the event that the buyer of a swaption wishes to reduce the amount of coverage, or in the case of a disagreement between the two parties, a swaption can be renegotiated or terminated in whole or in part during the period, against payment of an equalization payment. These cancellations / renegotiations can be considered as redemptions / resales swaptions, concepts already known at the options exchange.

• Transfer

An assignment of swaption does not satisfy the principle of the option is to disable or repurchase / resell if they disagree with his counterpart.

Swaptions market is very illiquid, the assignment of contracts does not seem to exist.

• Cancel

According to market rules, a transaction can not be canceled. To neutralize the position taken in a swaption contract, it is necessary to enter a reverse operation with the same characteristics.

However, it is necessary to enable the cancellation of a swaption transaction in the case of a mistake. The operating principle then joined the general principle of cancellation of the application.

Composites Products

One can also find” composites” or”” structured products involving several financial tools options. Similarly, some titles, this is the case of convertible bonds, can be analyzed as the combination of a conventional bond and an option to purchase.

• The degree course in
• The quota cap
• The course spread
• The cap up-and-out
• The floor down-and-out
• The tunnel
• ” ‘The degree to CAP”’

This product is intended for floating rate borrowers who want to ensure full coverage at higher rates, while enjoying the full potential declines, and, on payment of a reduced premium compared to conventional CAP. In exchange for this premium economy, CAP offers degrees in its two successive levels of buyer cap rate based on changes in the benchmark.

For each finding the floating reference rate, the level of rates found on the one hand is compared to the exercise price and, secondly, to limit the course to degrees.

Hence the following three possible cases:

• A) The rate determined is less than strike
• B) The rate is found between the strike price and the limit

C **) The rate is found over the limit

• A) The degree to CAP is not exercised. No payment is made.

The buyer recovers its initial state variable rate (prime + spread).

The buyer of CAP to receive degrees from lower rates.

B **) The CAP is exercised in degrees.

The buyer receives the CAP degrees to the differential between the observed and the strike.

Its debt ratio is at the strike (+ spread premium).

C **) The CAP is exercised in degrees.

The buyer receives the CAP degrees to the differential between the observed and the limit.

Its debt ratio is at the limit (+ spread premium).

Additional features of the CAP to CAP degrees compared to the classic:

Level ** limit, determined at the conclusion of the operation corresponding to the second level of the ceiling rate guaranteed.

• Purchase price: it is the amount of the premium payable by the purchaser, expressed as a percentage of the notional amount of origin. This cost is lower than that of a CAP standard even strike, the second level being higher than the ceiling guaranteed strike. The premium is usually paid immediately (D +2 working after the conclusion of the operation).

Termination **: it is possible at any time after the conclusion of the operation, if both parties agree. The amount of the balance of cancellation the buyer will collect will depend on market conditions at the date of termination.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• The CAP quota

The purchase of CAP quota is for floating rate borrowers who want to guarantee coverage to higher rates through a PAC without being penalized by the premium payment in the event that such coverage is their use. Indeed, payment of the premium associated with the CAP quota is not immediate and systematic, as is the case for a classical CAP, but conditioned by the crossing of a limit determined at the start. Thus, the premium payment may take place only when the CAP is activated (for a limit on the rise bustling presented in the graph below).

For each finding the floating reference rate, the rate level found is compared, first, to strike (the crossing of this level of rate triggering the exercise of the CAP) and secondly, to the limit (the Crossing this boundary conditions for payment of the premium or not).

Additional features of the CAP CAP quota compared to classical

Limit ** level and reversible or irreversible, activating or deactivating, or downward or upward rates.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• Purchase price: it is the amount of the premium payable by the purchaser whenever the CAP is exercised. The bonus applies to the notional amount covered during the reporting period. The payment of this bonus is conditional on the limit is exceeded.

Termination **: it is possible at any time after the conclusion of the operation, if both parties agree, the market conditions prevailing at the date of termination. Unlike the classical CAP, the termination of a CAP quota may, under certain market conditions, result in a cost to the purchaser of the output quota CAP, conditionality linked to the payment of the premium.

• The CAP spread

The purchase of spread CAP is designed for variable-rate borrowers who want to ensure a level ceiling on payment of a reduced premium compared to conventional CAP. They accept, in return, repositioning variable rate beyond a certain level of rates (strike CAP sold), but in this case receive a credit spread (difference between the strike of the CAP and CAP bought sold) which mitigates the cost of financing. This is a combined instrument for the buyer, the purchase of a CAP and sale of a second CAP same characteristics as the first (amount, duration, floating reference rate) but prices of exercise greater.

For each finding the floating reference rate, the level of rates is observed compared with two strikes of CAPs. Hence the following three possible cases:

• A) The rate determined is less than the strike bought CAP
• B) The rate is found between the two strikes

C **) The observed rate is higher than the strike price of the CAP sold

• A) CAPs are not exercised.

No payment is made.

The buyer recovers its initial state variable rate (prime + spread).

• B) The purchaser of the CAP has spread to lower rates.

Only the CAP purchased is exercised.

The buyer receives the CAP spread differential between the observed and the strike of CAP purchased.

Its debt ratio is at the strike (+ spread premium).

Both CAPs are exercised.

C **) The purchaser receives the CAP spread differential between the strike and sold the CAP CAP strike bought.

Its debt ratio after the rate increase (+ bonus spread – differential of strikes).

Additional features of the CAP spread compared to conventional CAP:

Strikes ** of two CAPs. They are committed to closing the transaction.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• Purchase price: it is the amount of the premium payable by the purchaser, expressed as a percentage of the notional amount of origin. The premium is usually paid immediately (D +2 working after the conclusion of the operation).

Termination **: It is possible at any time after the conclusion of the operation, if both parties agree. The amount of the balance of termination of the CAP that the buyer will cash spread will depend on market conditions at the date of termination.

• The CAP up-and-out

The purchase of CAP up-and-out is aimed at floating rate borrowers who want to guarantee a maximum rate of return for a reduced premium compared to conventional CAP. In exchange for this premium economy, they accept limited coverage at an interval determined initially. The premium payable is reduced due to the introduction of a limit beyond which the projection disappears.

For each finding the floating reference rate, the level of rates is observed compared to the terminals of the interval: if the variable rate is within the predefined interval, the CAP up-and-out is exercised and the seller pays the purchaser of the CAP rate differential between the observed and the strike of the CAP: if the variable rate is found outside the interval, the buyer recovers its initial state variable rate.

” Note”:

CAP up-and-out premium is a refundable coverage solution intermediate between a classical and a CAP CAP up-and-out. This product provides, when the interest rate cap is off (if the floating reference rate is found beyond the limit), the buyer shall be reimbursed for the premium for the period. In the case where the limit is crossed, and the borrower finds its initial situation without being penalized by the initial cost of the premium.

Additional features of the CAP up-and-out compared to conventional CAP:

Level ** knock limit the rate increase that is determined at the conclusion of the transaction. It is expressed in a directly comparable basis to the floating reference rate.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• Purchase price: it is the amount of the premium payable by the purchaser, expressed as a percentage of the notional amount of origin. This cost is much lower than that of a classic as the CAP rate range covered is limited. The premium is usually paid immediately (D +2 working after the conclusion of the operation).

It can also be spread over time, subject to payment of interest on credit so extended, and is then expressed as a percentage of the amount covered for each period. It may also, in the case of a CAP up-and-out premium refundable, be refunded to the buyer in each period where protection disappears (when the floating reference rate is found beyond the limits deactivating the increase).

Résilliation **: It is possible at any time after the conclusion of the operation, if both parties agree. The amount of the balance of cancellation the buyer will collect will depend on the level of expected cash rate on the remaining life of the operation, compared to the strike of the CAP up-and-out. If the premium payment was spread over time, the premium remaining due shall be paid only once, at the date of cancellation.

” ‘FLOOR The down-and-out”’

The purchase of FLOOR down-and-out is aimed at investors who wish to variable rates guarantee a minimum rate of return for a reduced premium compared to conventional FLOOR. In exchange for this premium economy, they accept limited coverage at an interval determined initially. The amount of the premium paid is effectively reduced due to the introduction of a limit below which the protection disappears. For each finding the floating reference rate, the level of rates is observed compared to the terminals of the interval: if the variable rate is within the predefined interval, the FLOOR down-and-out is exercised and the seller pays the purchaser of the FLOOR differential between the strike and the effective rate. If the floating reference rate is found outside the interval, the buyer recovers its initial position variable rate.

” Note”:

FLOOR The down-and-out premium is a refundable coverage solution intermediate between a classical and a FLOOR FLOOR down-and-out. This product provides that, where the interest rate floor is off (if the floating reference rate is found below the limit), the buyer shall be reimbursed for the premium for the period. In the case where the limit is crossed, the agent thus finds its initial situation without being penalized by the initial cost of the premium.

Additional features of the CAP up-and-out compared to conventional CAP:

Level limit ** knock down the rate determined at the conclusion of the transaction. It is expressed in a directly comparable basis to the floating reference rate.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• Purchase price: it is the amount of the premium payable by the purchaser, expressed as a percentage of the notional amount of origin. This cost is much lower than that of a conventional FLOOR since the range of rates cover is limited. The premium is usually paid immediately (D +2 working after the conclusion of the operation). It can also be spread over time, subject to payment of interest on credit so extended, and is then expressed as a percentage of the amount covered for each period. It may also, in the case of a FLOOR down-and-out premium refundable, be refunded to the buyer in each period where protection disappears (when the reference rate is found below the knock limit downward ).

Termination **: it is possible at any time after the conclusion of the operation, if both parties agree. The amount of the balance of cancellation the buyer will collect will depend on the level of expected cash rate on the remaining life of the operation, compared to the FLOOR strike down-and-out. If the premium payment was spread over time, the premium remaining due shall be paid in full on the date of cancellation.

• The Tunnel

The tunnel is for counterparties that wish to reduce or cancel (if the Tunnel zero premium) the cost of their coverage of debt (or investment) by renouncing benefit from falling (rising) of floating rate reference below (above) a certain level (ceiling).

This instrument corresponds to the simultaneous operations of purchasing a cap and selling a FLOOR (For a borrower Tunnel) or purchase a FLOOR and sale of a CAP (if a lender Tunnel ). In both cases, the CAP and FLOOR must have the same characteristics (amount, duration, floating reference rate).

” Example:”

In the example below, we consider the case of borrower Tunnel. For each finding the floating reference rate, it is compared to the exercise price of the CAP and the FLOOR. Hence the following three possible cases:

• A) The rate determined is less than the strike FLOOR
• B) The rate is found between the strikes of the CAP and FLOOR

C **) The observed rate is higher than the strike price of the CAP

• A) The purchaser of the Tunnel is in debt to fixed rate (strike of FLOOR). It does not benefit from lower money market rates below the strike price of the seller pays FLOOR as the Tunnel, the differential between the strike of the FLOOR and the effective rate.

The buyer of the tunnel is then variable rate debt. It benefits from lower money market rates (but also undergoes the increase in these rates) on this interval.

• B) The purchaser of the tunnel is then fixed rate debt (strike CAP). It is then covered against any increase in money market rates beyond the strike price of the CAP. It receives its counterpart the difference between the observed and the strike rate of CAP.

The premium to be paid under the CAP purchased is offset (in whole or in part) by the premium received for selling the FLOOR.

The chart below shows the debt ratio of a borrower at floating rate after the conclusion of a zero-premium Tunnel:

Additional features of the contract Tunnel:

Counterparts **: if the borrower Tunnel, the counterparty who buys and sells the CAP FLOOR (the buyer of the Tunnel) and one that sells and buys the CAP FLOOR (the seller of the Tunnel). And in the case of a lender Tunnel, the consideration that buys and sells FLOOR CAP (the buyer of the Tunnel) and the one that buys and sells FLOOR CAP (the seller of Tunner).

The CAP ** strikes (which is the level of rate caps) and FLOOR (floor rate which corresponds to). Both rates are expressed in a directly comparable basis to the floating reference rate.

Notional ** This is the amount on which the calculation of differential interest rates. It may vary during the lifetime of the operation according to a predetermined schedule. The original amount should be 2 million against its minimum or equivalent in foreign currency.

• Cost: The cost of setting up the tunnel is the difference between the premium and that of the CAP FLOOR. The premium is expressed as a percentage of the notional original. It is usually paid immediately (D +2 working after the conclusion of the operation), but can also be spread over time, subject to payment of interest on credit so extended, and is then expressed as a percentage of the amount covered each period. In the case of the Tunnel zero premium, strike levels of FLOOR and CAP are set such that the amounts of the two premiums are offset perfectly.

Termination **: It is possible at any time after the conclusion of the operation, if both parties agree.