# Interest rate options market

These IROs usually consist of strips of options of the same type and usually at the same strike rate, covering a series of successive periods. One of these contracts in a cap is referred to as a caplet , while a single contract in a floor is referred to as a floorlet. Interest rate caps are sometimes referred to as interest-rate calls because they go into the money if interest rates rise above the strike rate; likewise, interest-rate floors are sometimes referred to as interest-rate puts because they go into the money when interest rates decline below the strike rate.

Collars are established by buying a cap and selling a floor at a lower interest rate. The collar is a type of spread where one option is partly or wholly financed by selling another option. Most interest-rate collars consist of a long cap and a short floor.

The income from selling the floor is used to offset, wholly or in part, the cost of the cap. However, if the referenced interest rate drops below the floor, then the collar will lose money proportionate to the amount that the referenced interest rate drops below the floor rate. An interest-rate cap is simply a series, or strip , of caplets covering successive periods.

The caplets are priced according to expected future interest rates, so buyers will generally set the strike rates higher than current interest rates to save on the premium, in much the same way that the buyer of a stock option will buy an option with a strike price higher than the current stock price to pay a lower premium. Likewise, the strike rate of a floor will generally be set below current market rates to save on premiums.

For collars, where interest rate caps are bought and floors are sold to finance the caps, strike rate can be selected so that a zero-cost collar can be established. Interest-rate collars are generally bought as a package from an option dealer.

If the reference rate is above the cap rate, then the dealer pays the buyer the net difference between interest rates; if the reference rate is below the floor, then the buyer must pay the dealer the difference between the floor rate and the market rate at expiration multiplied by the notional principal; if the reference rate falls between the floor and the cap, then no payment is made by either party. An interest-rate swap is a contract in which the buyer of the swap agrees to a fixed rate of interest on a notional principal while the seller agrees to a floating rate, such as the libor, on that same notional principal.

If a floating rate is higher than the fixed-rate, then the seller pays the buyer; if lower, then the buyer pays the seller. A payer swaption is a European-style option that grants the holder the right to enter into a swaption. If the holder decides to enter into the swaption, then the interest rates are fixed for the contract period, and the buyer may have to pay the seller the difference in interest rates if the floating rate is less than the fixed rate. Thus, a swaption is less advantageous than a cap, a floor, or a collar, since the decision to exercise or not can only be made once for a payer swaption, but can be made on the expiration date of each cap or floor.

Similar to equity options, there are two types of contracts: A call gives the bearer the right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but not the obligation, to profit from a decrease in interest rates. The exchange of these interest rate derivatives are monitored and facilitated by a central exchange such as those operated by CME Group.

From Wikipedia, the free encyclopedia. This article does not cite any sources. Please help improve this article by adding citations to reliable sources. For collars, where interest rate caps are bought and floors are sold to finance the caps, strike rate can be selected so that a zero-cost collar can be established.

Interest-rate collars are generally bought as a package from an option dealer. If the reference rate is above the cap rate, then the dealer pays the buyer the net difference between interest rates; if the reference rate is below the floor, then the buyer must pay the dealer the difference between the floor rate and the market rate at expiration multiplied by the notional principal; if the reference rate falls between the floor and the cap, then no payment is made by either party.

An interest-rate swap is a contract in which the buyer of the swap agrees to a fixed rate of interest on a notional principal while the seller agrees to a floating rate, such as the libor, on that same notional principal. If a floating rate is higher than the fixed-rate, then the seller pays the buyer; if lower, then the buyer pays the seller. A payer swaption is a European-style option that grants the holder the right to enter into a swaption. If the holder decides to enter into the swaption, then the interest rates are fixed for the contract period, and the buyer may have to pay the seller the difference in interest rates if the floating rate is less than the fixed rate.

Thus, a swaption is less advantageous than a cap, a floor, or a collar, since the decision to exercise or not can only be made once for a payer swaption, but can be made on the expiration date of each cap or floor. Thus, the buyer can decide to exercise a caplet or floorlet on each expiration date of a cap or floor.

Eurodollar options give the holder the right to enter into a Eurodollar futures contract. Eurodollars futures prices are based on the anticipated US dollar USD libor interest-rate offered during the contract period on Eurodollar deposits — USD-denominated deposits held in banks outside of the United States. Eurodollar options can also be used to construct caps and floors. CME offers both calls and puts. A call gives the holder the right to enter into a Eurodollars futures contract, which benefits from falling interest rates.

A put gives the holder the right to sell a Eurodollar futures contract, which profits from rising interest rates. A put with the same strike price would simply expire worthless.

CME also offers mid-curve options , which are options on Eurodollar futures contracts covering 1, 2, and 5-year contracts. The reference rate for a mid-curve option is not a spot rate but a forward rate based on the value of a Eurodollar futures for the forward period. Mid-curve options, so named because they cover the middle of the yield curve , are short-dated options with terms of 1 year or less, with quarterly expirations plus the 2 front months.