This content explains how to manage interest rate risk exposure using options on interest rate futures, highlighting the flexibility these options provide compared to standard futures contracts.
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This time around we'll be looking at how
do we manage interest rate risk exposure
using this new strategy and what is that strategy
strategy
this time around I'm talking about
options on interest rate futures
remember that interest rate futures is
one of the strategies that you can use
just the same we had FRA the for rate
agreement and later We looked at options
on FRA which is also referred to as IRG
interest guarantee. This time around I'm
looking at options on interest rate
futures. So it's similar concept with FR
but remember FRA and futures are totally
different things. Yeah. So in as much as
it's similar is similar in a way that
the options on interest rate futures is
the same as interest rate futures. The
only difference is that if you do
interest rate features, you have an
obligation you must perform. But when
you put an options on top of it, it
gives you flexibility
on that feature, which means you still
have the features. However, you will
decide whether you want to use it or not
and you have to pay premium.
So few things I'll just mention to you
is first of all you need to know that
you are always going to be buying always
buying the options. Remember what you
are looking for is flexibility. So you
need to buy the flexibility. So you are
always buying and what are you buying?
You might be buying put or you might be
buying call. How do you know whether you
should be buying put or you should be
buying call? I'm I'm going to explain
later because it's totally different
from the concept of FRA. This time
around you'll be using the concept of
features. The same concept of features
to decide whether it's going to be a put
or it's going to be a call that you
need. Very important to know that. Yeah.
So beyond that you need to also know
that the outcome is similar to the
future. So which means the three things
we always talk about will still be
relevant here. your initial if you
decide to exercise remember that is if
you decide to exercise so which means
you're going to have the initial futures
that you're buying you're going to close
the futures by doing the opposite yeah
this means you are exercising the option
that's when you decide exercise then you
so once you decide to exercise
definitely those three things will now
come into play. If you don't exercise
then you're only left with the rate
transaction then definitely you're going
to have premium that will be involved
because before you can say to yourself
that you have an option you must have
paid a premium. So let me use this
question to explain to you what the
options means when we're talking of
interest rate futures. Yeah, remember
you need to know whether you need a put
or a call. That's the first thing you
have to decide. Do we need a put or do
we need a call? So, put or call.
And I'm going to explain it the same way
I explain interest rate features to you.
This time around, all you need to be
asking yourself is what you are trying
to do. How do you say it? If you need to
say it in terms of bonds. So which means
if you want to borrow what does it mean?
If your exposure is borrowing
which means you are planning to borrow
in the future. Then in terms of bond it
So which means your future transaction
is to sell bond. So if you want to put
an option on top of that, what you are
to sell a bond. That is what it means in English.
So this is borrowing. That is what this
means. So which means if it is
borrowing, you are trying to hedge.
Remember if you're using features you
must always initiate your future
transaction in the same direction as the
uh the real transaction. So your future
transaction will be your real
transaction. So which means your future
transaction is to sell a bond which is
the same thing as your real transaction.
And if you want an option on it then buy
an option on it. And what is an option
to sell a bond? An option to sell a bond
is a put option.
So which means for borrowing, if you
what you must do is to buy. Remember,
you will always buy an option because
you are the one that want the
flexibility. So you buy a put. That's
what makes the difference. That makes it
boring. Buy a put on interest rate future.
future.
So which means remember when you
exercise your profit or gain will be
determined from how you open and close
the interest rate features then overall
impact will now be when you bring that
into your outcome of your rate
transaction. But if it's to be a deposit
or investment,
if you look at it in forms of bond, what
you are trying to do is to buy a bond.
Because when you buy a bond that you
invest, that is synonymous to buying a
bond. You are the one that is giving out
your money for returns and redemption in
the future. So buy a bond and if you
want to add an option to it then it
means you are buying
an option
to buy a bond
that's what it means
and in that case what you are trying to
buy the option to buy is a call. So
which means if it's a deposit you are
using a call. So that is how you will
know when to use call or to use put and
if you notice is directly opposite to
FRA because FRA when you are buying it's
a borrowing
because you are not looking at the
principle you are just looking at the
rate only so who is paying rate so
borrowing means you are paying interest
so paying means you're buying something
that's how it works in that so you need
to be able to understand how these
strategies differ and how you solve it
when you see them in question.
Yeah, still looking at this question.
Maybe I should bring this question a bit
down so we can start looking at it in
Yeah, let me put it here. So, we have
this question. Take few seconds and look
at it. Yeah. So, because this is talking
about borrowing. Yeah. So, should
calculate the result of that options
edge. The plan is to borrow 10 million
in a month's time for a tenor of 6
months. So is a borrowing. So number
one, we know that what we need is a put option.
option.
Now please pay attention to this. The
next thing you ask yourself is what's
and pay attention to this please. I
don't want to miss this. I'm going to
use this question to explain this. How
do you know the strike price that you
need? See, you have four different types
of strike prices available. What you
must always understand is if you are
selling, you want the highest
inflow for sure if you are going to
receive money. If you think you're going
to receive money, but remember
that the option we are talking about
here is a put option in this regard. And
a put option in this regard means that
we are selling a bond. But we are not
talking about the price of a bond here.
Yeah, pay attention like I said so you
don't get confused with the word sell.
We are selling a bond. Yes, but in the
risk that we are trying to manage is
interest rate. So at a rate
which is a paying rate this is an
expense to us.
So which means unlike when we just look
at put and say oh is inflow then want to
maximize it. It's different. A put here
is actually a problem for us. Is a is an
expense for us, a liability for us
because we need to pay in interest we
are talking about. In that case, we want
to go for the lowest interest rate. So
lowest net interest rate.
That's what we want to go for. And you
understand that for deposit it will be
the opposite. You want to go for the
highest net interest rate. Yeah. And how
do you go about this
exercise price? The first you need to do
is to take it to interest rate quickly
so that you know what it means. And this
This one will be five. And this one will
be 4.75.
So you already know what it means for
that rate. But beyond this rates for
this excise prices they give us premium
that are quoted in percentage. This
is.18% this one is not available so
we're not going to deal with it. So
which means
we are going to pay this for put pay
this for put pay this for put in
addition to all the strike price. So
which means the net interest rate for
strike price of 9475
is actually
You see if it was call it to be
different because for call all this
interest that we have labelled here will
be inflow and this will be expense. So
we'll just be deducting that will form
the net for call. So if we're talking
about core for instance
it will be 5.25
minus 1.02 and you have add something
like 4.23 here 4.35 4.54
4.54
and for so for call you want the highest
because buying bonds means you are
expecting to receive interest. So for
call you would have gone for the strike
price at this level but for put we want
the lowest and this is the lowest. So
which means the strike price I will be
So we already know that that will be the
strike price of our option. Once you
sort that one out then you ask the next
question. How many contracts? Because
remember before I always warn you before
you compute your premium on option you
need to know how many contract you need
and you must always compute your premium
on the number of contract because
sometimes you might have some amount
that you cannot edge because of the
restrictions coming from your
quantity or size of your contract. So
these questions already told us that the
total sum we need is 10 million and each
contract is 500,000.
But remember as I always told you during
the interest rate future that we looked
at interest rate is driven by period in
remember interest itself is equals to
the rate
time principle time.
time.
So when you are dealing with interest
rate risk you must not forget this tenor
and that is why to know the number of
contracts we are not just going to say
The popular mistake student makes just
the transaction size divided by the
contract size. No this will not be
correct. This one we need to aortion
with time. So we need to first of all
divide it by the total tenure of the
contract this time around which is three.
three.
Yeah it gave us. Then you multiply by the
the
tenor of the transaction which is six in
this regard. And in that case the
transaction size is 10 million contract
size is.5 million
and time 2 6 / 3 and that will give us
So we know the number of contract that
we need. Then our life is super easy
because now we can now go to step four
There is no option contract without
premium. So you must calculate premium.
Premium that is applicable in this
question is 0.18%.
So you need to do premium per contract.
always start like that so that you know
that once you have this is just to
multiply by the number of contract you
bought. So stay on the premium per
contract and your premium will always be
your rate. Remember just like it's
interest expense we are calculating
that's the premium rate times principal time
it's just simple you don't need to
memorize it your rate is 0.18% you know
rate is always annual yeah the principle
of the contract is 500 so every contract
has a principle of 500,000
so put that here
and this contract is for 3 months they
told us so we need to annualize ize that
in 3 months which makes it 3 / 12. And
if you look into that quickly on the
calculator, this will give us $2 to5.
But we know definitely that we have 40
contract. Yeah. So for if that's for one
contract, 40 contract will be 40 * 2 to5
which is equals to $9,000.
Simple, easy. That's the premium.
Now, once we So, once we pay this
premium, the next thing is for us to now
wait until the transaction date, which
will be in a month's time
because that's when we know whether
we're going to exercise or will not
exercise. So, we need to check whether
the market has moved against us or in
our favor. And if you look at what
they've said about the market, they said
the future interest rate see interest
rate has risen to 7.5. So if we have an
option at a strike price of 94.75
which is invariably 5.25%.
5.25%.
So we have an option to actually pay
interest at 5.25 and market has gone to
7.5 then that option definitely is in
and like I said once we decide to
exercise then the future transaction
come in all together. So initiation begins
begins
actually a sell because we bought an
option to sell.
We bought a put. So that's how we
initiated the bond. So initation
at 94.75.
Then we need to close it because we're
exercising the option. So which means
we need we must have bought this bond
that means we have exercised because
remember the option that we buy yeah is
that we always buy the option to
sell a bond if it's a borrowing and that
is what we bought here put that's why we
said a put option so if we are going to
exercise this put option we will buy the
bond future So we exercise means that we
bought we decided to sorry we we decide
to sell the bond futures because what we
is a put option an option to sell rather
sorry right so it means we going to sell
that future so that's why we exercise
this means we've exercised so that's
what it means and if we have sold bond
future at that strike price then we need
to close it and what do we need to do we
will We're going to close it by buying
and the question told us that
on that date future price has moved to 93.
93.
So that'll be at 93.
And if you try to get the difference
between that that
fact before I show you the difference,
let me just write it that is 1.75%.
For sure. But just to explain a bit more
for you. Remember selling bond future
means borrowing. It means you are paying
interest at So
However, when you buy a bond, buying a
bond is like an investment. So, which
at 7%. And you can see why this is
actually a gain.
will be equals to 1.75%. Remember this
is annual rate. Always remember please
very important not to get carried away
with this rate. It might mean a lot
between you passing and not passing. So
it's 1.75%
everything you must do it per contract
if not you might run into problem with
questions that you are not able to edge
fully I'll keep reminding you and the
tenor is always 3 months for the
contract so you analyze it and if you
press your calculator for this you see
that for each contract you have a gain
of $2,187.5 $5.
$5.
And if that is the case for 40
contracts, which means you're going to
multiply by 40,
that will give 87,500
87,500
total profit. So this is your total
profit on the contract.
So which means out of three things
you've initiated and you've closed
future two things done and we have this
figure from those two things then we
need to finalize it by doing the third
one which is the real transaction and
the real transaction will happen at the
spot market rate which they've already
told us is at um I think 7% 7.5%.
Yeah. So which means the 10 million will
actually be at 7.5% in reality.
So that's 7.5% as 10 million will
happen. But remember that
the rate transaction has a tenor of 6 months.
months.
Yeah. Convert it to years. Then this
will be 7.5% of 5 million which is
So which means normally this transaction
will require us to pay this but good
enough we've done some edging and we
have some savings from here. So which
means the net in real time will be we
need to reduce our interest by that 87,500
87,500
and eventually the net cost
will be the difference between the two
and that is how interest rate
features will work when you have options
on top of it. If there was no options on
top of it,
then you don't have the flexibility. But
it doesn't make any difference in your
calculation. The only difference is just
that there's now 9,000 with options.
That is additional cost to you. So which
means even for you to finish final final
you need to deduct your premium.
premium.
So which means you add it is an expense.
Plus is an expense. So they're both
expense and if you add that together
you have the total
liability expense for you is 0 0 this is
five and um
six trying to do it on top of my head 9
and three so
that's 396 6 no 296 sorry 296
that be 296 in total so you consider all
the options together yeah
add them together remember this negative
is showing that is an expense but to
avoid confusion let me just take all the
negative so that we know that we're
talking about them as cost so they are
both cost since they are both cost It's
easy. So
premium is a cost is a net cost and
that's that's a total 29659. So that's
the real situation
on the options. Yeah, I'm saying it
again. The options on interest rate
features is not different from interest
rate features. The only thing that just
slightly different is when you don't
plan to
exercise, there is no interest rate
features. But once you exercise is the
same thing just plus premium that you
have to add to it. But if you don't
exercise only premium and the rate
transaction is what you have left.
Please take notes and let me know if you
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