Interest rate options

Options are used to manage the risk-return trade-off from a particular exposure or position. They are a
form of insurance, where a premium is paid upfront, and the option is only exercised if an unfavourable
event occurs.

Options provide the right, but not the obligation to buy or sell the underlying asset or financial instrument
at a fixed rate, on or before a fixed future date. In the case of interest rate exposures, the underlying asset
or financial instrument is the floating interest rate itself (e.g. BBSW).

Options provide flexibility in the management of interest rate exposures, as they allow the purchaser to
benefit from favourable movements, whilst protecting against unfavourable movements. For this flexibility,
the option buyer pays the option seller an upfront premium, which reflects the price of that option.

A bought interest rate call option, or cap, provides the right to borrow at the strike rate. This is useful for
organisations planning to borrow in the future to hedge against unfavourable (or upward) movements in
floating interest rates.

- The pay-off for a bought, or long, cap is: Max [BBSW – Cap rate, 0]. This formula means that the call
option payoff is the maximum of the ‘BBSW rate less the cap rate’, or zero. That is, the payoff
cannot be less than zero.
- The profit from the bought, or long, cap is: Max [BBSW – Cap rate, 0] – Cap premium. This formula
can be interpreted as the pay-off from the long cap, less the cap premium paid.

A bought interest rate put option, or floor, provides the right to invest at the strike rate. This is useful for
organisations planning to invest in the future to hedge against unfavourable (or downward) movements in
floating interest rates.

- The pay-off for a bought, or long, floor is: Max [Floor rate – BBSW, 0]. This formula means that the
put option payoff is the maximum of the ‘Floor rate less BBSW’, or zero. That is, the payoff cannot
be less than zero.
- The profit from the bought, or long, floor is: Max [Floor rate – BBSW, 0] – Floor premium. This
formula can be interpreted as the pay-off from the long floor, less the floor premium paid.

The effective interest rate on a transaction includes the impact of the premium.

- When we buy an interest rate call option, we add the premium to the strike rate to determine the
effective rate. That is, a borrower pays a little more than the strike rate when it calculates its
effective borrowing rate.
- When we buy an interest rate put option, we subtract the premium from the strike rate to
determine the effective rate. That is, an investor receives a little less than the strike rate when it
calculates its effective investing rate.

Interest Rate Cap – Example

An organisation has an upcoming borrowing requirement of $2 million for 90 days, starting in 3 months’
time. The organisation plans to issue bank bills (i.e. discount securities) based on the BBSW floating rate,
and it wants to protect against rising rates. The organisation decides to purchase an interest rate cap that
matches the borrowing requirement, and has a strike rate of 4.00%. The organisation’s resulting cash flows
under multiple scenarios are as follows:

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 Scenario 1: Scenario 2: Scenario 3:
BBSW < Cap rate BBSW = Cap rate BBSW > Cap rate
1. Actual BBSW rate at expiry 3.50% 4.00% 4.50%
2. Organisation's gross proceeds $1,982,887 $1,980,467 $1,978,052
3. Long cap pay-off $0 $0 $2,415
4. Organisation's net proceeds $1,982,887 $1,980,467 $1,980,467
5. Effective borrowing rate 3.50% 4.00% 4.00%
(BBSW) (BBSW or Cap rate) (Cap rate)

Notes:

Item 1: this is the BBSW rate that applied at maturity of the cap and the start of the actual 90-day borrowing
period. In Scenario 2, the actual BBSW matches the cap strike rate of 4.00%.

Item 2: this is the organisation’s gross proceeds from the money-market discount security. It is calculated
using the formula: Present Value = Principal / (1 + (r × n / 365)). In Scenario 1, for example:

PV = $2,000,000 / (1 + (0.035 × 90 / 365))

= $2,000,000 / (1.008630137)

= $1,982,887

Item 3: this is the pay-off from the long cap, that is, the hedging instrument. The cap expires worthless in
Scenarios 1 and 2 as the BBSW is not higher than the cap rate. The organisation simply lets the cap lapse.
However, in Scenario 3, the cap has value and would be exercised by the organisation. The long cap pay-off is
calculated as Max [BBSW – Cap rate, 0]. In rate terms, this becomes: Max [4.50% - 4.00%, 0], which equals
0.50%. In dollar terms, we need to calculate the present value of the discount security at 4.00%, and subtract
the present value of the discount security at 4.50%. That is:

PVCap = $2,000,000 / (1 + (0.040 × 90 / 365)) = $1,980,467

PVBBSW = $2,000,000 / (1 + (0.045 × 90 / 365)) = $1,978,052

Long cap pay-off = PVCap – PVBBSW

= $1,980,467 – $1,978,052

= $2,415

Item 4: this is the organisation’s net proceeds, after taking into account the gross proceeds and the long cap
pay-off. In Scenario 3, we can see that the net proceeds of $1,980,467 match the net proceeds as in Scenario
2, which is the cap rate. Note that this example has not taken into account any premium paid upfront.

Item 5: this is the effective borrowing rate for the organisation, after taking into account the pay-off from the
cap. The effective rate in Scenario 3 matches that in Scenario 2, and highlights how the cap worked to put a
ceiling on the borrowing rate at 4.00%.

At maturity of the cap, if the BBSW rate is above the strike rate, such as in Scenario 3, then the borrower
will exercise the option and borrow at the lower rate of 4.00%. However, if the BBSW rate is equal to or
below the strike rate, such as in Scenarios 1 and 2, then the borrower will let the option lapse, and simply
borrow at the applicable BBSW rate. This highlights how the interest rate cap has been able to cap the
borrowing at the strike rate of 4.00%, while still allowing the organisation to take advantage of favourable
downward movements in interest rates.

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Interest Rate Floor – Example

An organisation will make an upcoming investment of $4 million for 180 days, starting in 2 months’ time.
The organisation plans to invest in bank bills based on the BBSW floating rate, and it wants to protect
against falling rates. The organisation decides to purchase an interest rate floor that matches the
investment structure, and has a strike rate of 3.00%. The organisation’s resulting cash flows under multiple
scenarios are as follows:

Scenario 1: Scenario 2: Scenario 3:

BBSW < Floor rate BBSW = Floor rate BBSW > Floor rate
1. Actual BBSW rate at expiry 2.50% 3.00% 3.50%
2. Organisation's gross outlay ($3,951,286) ($3,941,685) ($3,932,130)
3. Long floor pay-off $9,601 $0 $0
4. Organisation's net outlay ($3,941,685) ($3,941,685) ($3,932,130)
5. Effective investment rate 3.00% 3.00% 3.50%
(Floor rate) (BBSW or Floor rate) (BBSW)

Notes:

Item 1: this is the BBSW rate that applied at maturity of the floor and the start of the actual 180-day
investment period. In Scenario 2, the actual BBSW matches the floor strike rate of 3.00%.

Item 2: this is the organisation’s gross outlay from investing in the money-market discount security. It is
calculated using the formula: Present Value = Principal / (1 + (r × n / 365)). In Scenario 1, for example:

PV = $4,000,000 / (1 + (0.025 × 180 / 365))

= $4,000,000 / (1.012328767)

= $3,951,286

Item 3: this is the pay-off from the long floor, that is, the hedging instrument. The floor expires worthless in
Scenarios 2 and 3 as the BBSW is not lower than the floor rate. The organisation simply lets the floor lapse.
However, in Scenario 1, the floor has value and would be exercised by the organisation. The long floor pay-off
is calculated as Max [Floor rate – BBSW, 0]. In rate terms, this becomes: Max [3.00 – 2.50%, 0], which equals
0.50%. In dollar terms, we need to calculate the present value of the discount security at 2.50%, and subtract
the present value of the discount security at 3.00%. That is:

PVBBSW = $4,000,000 / (1 + (0.025 × 180 / 365)) = $3,951,286

PVFloor = $4,000,000 / (1 + (0.030 × 180 / 365)) = $3,941,685

Long floor pay-off = PVBBSW – PVFloor

= $3,951,286 – $3,941,685

= $9,601

Item 4: this is the organisation’s net outlay, after taking into account the gross outlay and the long floor pay-
off. In Scenario 1, we can see that the net outlay of $3,941,685 match the net outlay as in Scenario 2, which is
the floor rate. Note that this example has not taken into account any premium paid upfront.

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 Item 5: this is the effective investment rate for the organisation, after taking into account the pay-off from
the floor. The effective rate in Scenario 1 matches that in Scenario 2, and highlights how the floor worked to
prevent the investment rate falling below 3.00%.

At maturity of the floor, if the BBSW rate is below the strike rate, such as in Scenario 1, then the
organisation will exercise the option and invest at the higher rate of 3.00%. However, if the BBSW rate is
equal to or above the strike rate, such as in Scenarios 2 and 3, then the organisation will let the option
lapse, and simply invest at the applicable BBSW rate. This highlights how the interest rate floor has been
able to keep the minimum investment at the strike rate of 3.00%, while still allowing the organisation to
take advantage of favourable upward movements in interest rates.

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