Hedging the risk of interest rate fluctuations by buying or selling interest rate options

This page was last modified on 30-01-2013

An interest rate option is an agreement between 2 parties, the purpose of which is to cover a business against the risk of unfavourable interest rate fluctuations. Used to set the minimum or maximum rate of a future transaction, interest rate options are generally traded over the counter (OTC).

They give the buyer the right (but not the obligation) to borrow or lend a certain amount at a fixed interest rate (strike rate) during a certain period or on a specific date. In exchange for the right to exercise this option, the buyer will pay the seller a premium when the transaction is concluded.

Depending on how the relevant interest rate moves, the buyer may choose whether or not to exercise this option on the due date, thereby keeping the possibility of benefiting from a positive movement.

Who is concerned

This is intended for medium or large borrowing or lending businesses seeking to hedge the risk of future interest rate fluctuations. They can use an interest rate option as:

  • an instrument for hedging an investment:
    • setting the current interest rate for a future investment (inflow of cash);
    • protection against possible interest rate decreases, while continuing to benefit from stable or rising interest rates in the future.
  • an instrument for hedging a loan:
    • setting the interest rate for standard credit or loans with a variable or adjustable rate (roll-over credit);
    • setting a lending rate to finance an investment that is planned but not yet carried out, etc.

With an option, the buyer acquires the right to borrow at a maximum interest rate or to lend at a minimum interest rate for a specific period and for an amount determined in advance.

Prerequisites

Presentation of the application

Explanation of the underlying financial transactions to the bank.

Guarantees

Some interest rate hedging transactions represent a credit risk for banks, causing them to analyse the applicant business and submit the application to the credit committee. It is not, however, customary for the bank to request tangible guarantees for this type of transaction.

How to proceed

Duration and payment

Amount

In view of the cost and complexity of interest rate options, a minimum amount is strongly recommended.

Duration

  • short to medium-term;

  • duration varies from a few days to several years;

  • option may be exercised during a given period (American option) or at a specific date (European option).

Premium/Margin

The premium of an interest rate option to be paid by the buyer depends on various factors, namely:

  • the level of the interest rate hedged by the option;

  • the market interest rate of the day;

  • the volatility of the underlying;

  • the duration.

The premium is always paid when the agreement is concluded and may not, under any circumstances, be recovered by the buyer.

Payment of a balancing amount or differential

On the exercise date of the interest rate option, the buyer has the possibility of either exercising the option or letting it expire:

  • an interest rate option buyer that wants to borrow will exercise their right if the market interest rate of the day is higher than the agreed interest rate;
  • an interest rate option buyer that wants to lend will exercise their right if the market interest rate of the day is lower than the agreed interest rate.

If the option is exercised, the seller of the option only has to pay the buyer of the option the difference between the reference interest rate and the strike rate.

Set-up times

The reviewing and processing times depend on the complexity, size and urgency of the case.

Advantages, disadvantages and risks

Advantages

  • the borrowing (lending) business is protected against an excessive rise (fall) in interest rates by a guaranteed maximum (minimum) rate;

  • flexibility: the rate is predetermined for current or future borrowings (loans) depending on the market situation and the business' expectations, while still allowing the business to benefit from possible interest rate falls (rises);

  • possibility of reversing the transaction at any time given that it is a very liquid market;

  • makes budgeting easier as the minimum (maximum) amounts to be received or paid are known;

  • easy to manage, recorded off-balance sheet for the business.

Disadvantages

  • the premium must be paid by the buying company (regardless of how interest rates move). It can sometimes be quite high, especially for a long duration or when interest rates are experiencing major fluctuations;

  • opportunity cost if the option is cancelled for a new, more beneficial purchase.

Risks

The only risk for the buyer associated with an interest rate option is the premium.