Interest rate options are financial derivative contracts that enable investors to speculate or hedge against directional changes in interest rates.
Interest rate options can be exercised at the strike price of the contract which is a pre-determined rate of Interest.
Interest rate options are cash settled.
As with equity options, an interest rate option involves a premium payment to enter into the contract.
Interest rate options are of two types: call option and put option.
An interest rate ‘call’ option contract gives the holder the right to benefit from rising interest rates.
At the time of option expiry, if the spot interest rates have increased and are trading above the strike price at a level sufficient to cover the premium paid to enter the contract, the investor who is holding the call option makes a profit.
Similarly, an interest rate ‘put’ option contract gives the holder the right to benefit from falling interest rates.
If, at the time of option expiry, the spot interest rates have fallen and trading at such levels below the strike price, that the investor is able to recoup the premium paid at the time of entering into the put option contract, he/she is able to make a profit from the contract.