What are Interest Rate Options?

Interest rate options are a type of investment where the return is based on how interest rates fluctuate during the time that the investor holds onto the options. The investment may be structured as a call option or a put option. Purchasing interest rate options may take place in an over-the-counter setting or through trading activity on an exchange.

The strategy of determining how to make the most of interest rate options is to accurately project what will happen to prevailing interest rates over a period of time. For example, if an investor finds there is a high probability that interest rates will increase steadily over a specified period of time, he or she may choose to go with an interest rate call option that involves a long-term investment. At the same time, if there is a good chance that the rates will decrease within a given time frame, the investor may prefer to structure the investment as a medium or short-term put option, making it possible to sell the investment before the decrease actually commences.

In many instances, interest rate options are offered on Treasury bond futures that are connected with bonds issued by the United States Treasury, as well as Eurodollar futures. Choosing the term for the options is often based on a number of factors, including the rate of recession or inflation that is currently taking place, and the projected movement of the economy over the next several years. Factors such as upcoming political elections and how the outcome of those elections would affect the economy are also key in evaluating both how long interest rate options are held and whether they are structured as put or call options.

Along with accounting for future movements in the prevailing interest rate, investors also look closely at how significant those rate changes will be over time, and if the rate will remain above the combination of the strike price and the premium that the investor would pay for the option. The idea is that carefully projecting the movement of the interest rate makes it possible to determine when to buy and when to sell the options to earn the maximum return possible. This calculation must also involve the task of identifying what type of return is needed to offset all acquisitions costs, including any fees and taxes that are payable during the time that the investor holds the interest rate options.