Interest rate futures and options are relatively unusual financial instruments. They certainly provide an interesting topic for a cocktail party, as most people have never even heard of these. It is important to understand how these exotic instruments work before you trade them, as you can easily lose large sums of money in in the futures and options market.
There are two kinds of basic options, as well as a wide variety of more complicated ones. Most options that are traded, however, are either plain puts or plain calls. A put gives the holder the right, but not the obligation, to sell a specific asset at a predetermined price on or before a specific date. A put on 100 Microsoft shares with a strike price of $30, expiring July 15, for example, allows the holder to sell 100 shares of Microsoft for $30 each on or before July 15. If the price of Microsoft is below $30 in the market, the holder will find it profitable to exercise this right. A call option with the same characteristics allows the holder to buy Microsoft at $30 each, and will be exercised only if Microsoft is trading at more than $30 per share by the expiration date.
A futures contract is an agreement between two parties to sell an asset at a specific price and date. A futures contract can be for 100 Microsoft shares at $30 per share and be set for execution on July 15. Unlike options, futures are not optional and must be executed. The seller must deliver said shares at the specified price, and the buyer must purchase them. A futures contract is legally binding for both parties.
Interest Rate Options
When the underlying asset that the option is tied to is a specific interest rate, such as the rate on the government-issued 10-year Treasury note, it is not possible to buy or sell it in the conventional sense. Instead, such an option will specify the amount of money that will change hands between the buyer and the seller for each point by which the market rate at the time of expiration differs from the contractual rate. For example, the contract may stipulate that the buyer of the call will be paid $10,000 for each point, by which the interest on the 10-year note exceeds 3 percent. So if the rate is four point five 4.5 percent, the buyer would be paid $15,000. If, however, the rate is below 3 percent, the buyer pays nothing and owes nothing.
Interest Rate Futures.
The difference between an interest rate option and interest rate future is that some money will always change hands with futures, except in the unlikely situation where the prevailing rate at expiration is exactly equal to the contractual rate. So if the contract is between A and B, A may pay B $10,000 for each point by which the specified rate exceeds 3 percent. However, B would have to pay A $10,000 for each point by which the rate falls below 3 percent. Both parties would owe nothing only if the rate is exactly 3 percent at expiration.
For the individual investor, interest rate options and futures are most useful in hedging interest rate exposure. If, for example, your variable-rate mortgage will cost $10,000 more for every percentage point rise in mortgage rates, you can structure a futures trade that will pay exactly $10,000 for each percent gain in mortgage rates. As such you can mitigate a rise in your mortgage payments. If, however, you place money in interest rate options or futures not to hedge an interest rate risk but to bet on interest rate movements, sudden changes in rates can result in substantial losses.
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