Decoding Interest Rate Options

Hola traders in finance! There is a new financial derivative introduced by Reserve Bank of India (RBI), effective from January 31,2017. Traders can now gain by speculating on interest rates as well. This will enable all domestic entitles that have underlying interest rate risk to hedge their risk by trading in newly christened derivatives.

What are interest rate options?

Typically an interest rate option is the one that derives its value form the change in interest rates. Before we delve into details it is pertinent to understand what are options?

Options are contracts where the purchaser of the option has the right but not the obligation to either purchase or sell and the seller of the option is obliged to sell underlying at a price agreed in advance.

Types of interest interest rate options –

1. Cap- An interest rate cap is an interest rate option in which the buyer of the option receives a pay-off when the reference rate is above the strike rate on expiry. They are designed to hedge against the risk of rising interest by payment of premium to the other party who promises to pay the interest on specified future dates

2. Floor - An interest rate floor is an interest rate option in which the buyer of the option receives a pay-off when the reference rate is below the strike rate on expiry. In this option guarantee is given that the interest rate will not fall below the stated minimum.

3. Collars-Interest Rate Collars are derivative contracts where a market participant simultaneously purchases an interest rate cap and sells an interest rate floor on the same reference rate for the same maturity and notional principal amount. A reverse interest rate collar is a derivative contract which involves simultaneous purchase of an interest rate floor and sell of an interest rate cap on the same reference rate for the same maturity and notional principal amount. 

Where can you trade in interest rate options?

Interest Rate Options are permitted on exchanges authorized by SEBI as well as in the Over-the-Counter (OTC) market. Also, exchange that will introduce interest rate option needs to obtain a prior approval from RBI. Currently only European options are allowed.

Who can deal in Interest rate options?

Any user carrying underlying interest rate risk. They can enter into interest rate option contracts for hedging underlying risk.

What will be reporting mechanism for Interest rate option?

All over the counter transactions pertaining to interest rates shall be reported to Clearing Corporation of India Limited within 30 minutes The RBI Directions provide that OTC transactions shall be settled bilaterally or through RBI-approved clearing arrangements of trade.