Interest Rate Options

Start with the option payoff

An interest rate option provides a right linked to a specified rate or interest-sensitive instrument. A call on a bond futures price benefits from that price rising, generally as yields fall. A cap on a borrowing rate protects against the rate rising instead. Identify what the strike measures before deciding between calls and puts.

The buyer pays a premium for the right; the seller accepts the corresponding obligation. Strike, premium and expiration together determine whether a favorable price movement produces a profit.

A simple call example

For an illustrative one-unit option, assume a 100 strike and a 5-unit premium. At expiry with the underlying at 112, the call has 12 units of intrinsic value and a 7-unit gain after premium. At 103, it loses 2 units; at 100 or below, it loses the entire 5-unit premium. Breakeven is 105.

A simple put example

With the same hypothetical strike and premium, a put has 12 units of intrinsic value if the underlying finishes at 88. The gain is 7 units after premium. At 97, it loses 2 units; at 100 or above, the entire premium is lost. Breakeven is 95.

These values teach the arithmetic. The market and product lessons use their own quotations, quantities and settlement rules. Equal premiums in the two examples are an assumption, not market data.

What the examples do not show

A correct price view does not guarantee a profit. The move must be large enough and arrive before expiry to recover the premium. Before expiry, time remaining and implied volatility affect the price available when selling to close.

The premium limits the standalone purchased option’s loss. Exercise can create another position requiring funding or margin, and keeping that position introduces further risk. An uncovered seller can lose much more than the premium received.

Choose your next lesson

SOFR Options — Continue with the focused explanation and examples.

Treasury Note Options — Continue with the focused explanation and examples.

Treasury Bond Options — Continue with the focused explanation and examples.

Interest Rate Caps, Floors and Swaptions — Continue with the focused explanation and examples.