1.2 Interest Rate Options
This topic describes the Interest rate options in OT module.
An IRO is an interest rate risk management product – it protects the buyer from an adverse movement in interest rates.
A borrower of floating rate funds is inconvenienced by a rise in interest rates, while a lender is adversely affected by a fall in floating rates.
An IRO gives the buyer the right, but not the obligation, to fix the rate of a notional underlying loan or deposit for a specified period, commencing on a specified date. Thus, the buyer of an IRO is protected against the interest rate rising above (if she is a borrower) or falling below (if she is a lender) at a specified level. At the same time, the buyer of an IRO can enjoy the benefits of the interest rate staying below (if she is a borrower) or stay above (if she is a lender) the specified level.
IROs is any one of the following categories:
- Cap – an option that gives the holder right to enter into strips of notional future borrowings at a pre-agreed interest rate
- Floor – an option that gives the holder the right to enter into strips of notional future lending at a pre-agreed interest rate
- Collar – an option strategy that involves a purchased cap and a written (sold) floor
- Corridor – an option strategy that involves two caps purchased at different exercise prices
Note:
An IRO does NOT have an implied commitment by either counterparty to exchange the notional principal at any stage – so no credit has to be given (no debt security purchased) or deposit accepted (debt security sold) by either party.This also means an IRO is entered with a pure speculation objective, only to hedge against adverse interest rate movements.
Parent topic: Overview of Over the Counter Options