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Using interest rate options

A forward rate agreement (FRA) allows a company to enter into a forthcoming transaction at a guaranteed interest rate. »Ê¹ÚÌåÓýapp drawback is that the company is then tied in to that rate - it cannot profit from advantageous movements in interest rates. In the example at CFM13300, the company is effectively tied in to borrowing at 5.4%, even if commercial interest rates have fallen well below that.

Interest rate options provide companies with a guaranteed maximum rate at which they can borrow (or a guaranteed minimum return on deposits), while still allowing the company to take advantage of favourable movements in interest rates. This kind of freedom of action is not cheap - an up-front premium will be payable.

Example

»Ê¹ÚÌåÓýapp facts are as in CFM13300. Cludwin Ltd wants to borrow £12 million in 6 monthsâ€� time. It expects that it would have to pay a fixed rate of 12-month sterling LIBOR plus 0.2% over the 12-month period of the loan. 12-month sterling LIBOR is currently 5.1%, but the company is concerned that interest rates will rise in the interim. It does not want to have to pay more than 5.4% for its funding.

»Ê¹ÚÌåÓýapp company buys an interest rate option from its bank, with a strike price of 5.2%, and an expiry date 6 months hence. (It buys what is called a borrower’s option - one that pays out if interest rates rise above the strike price.) It pays the premium quoted by the bank - say £10,000.

At the exercise date, 12-month sterling LIBOR has risen to 5.5%, so the company exercises the option. »Ê¹ÚÌåÓýapp option is cash settled. »Ê¹ÚÌåÓýapp bank pays Cludwin Ltd a cash sum of

(5.5% - 5.2%) x £12,000,000 x 1 years = £36,000,

discounted for early settlement (because the company is getting this cash sum at the start of the loan, but it will not have to pay interest until later). »Ê¹ÚÌåÓýapp net effect is that the company borrows at 5.4%.

However, had 12-month sterling LIBOR fallen below the strike price of the option, the company could simply have let the option lapse. Suppose that LIBOR is 5% when the company comes to take out the loan, Cludwin Ltd can take advantage of the fall in interest rates by borrowing at 5.2%.