Limitations of Interest Rate Futures
- Basis risk is incurred when the maturity date of borrowing or lending does not
coincide with maturity date of a futures contract, - Risk of correlation is incurred when the rate covered is not perfectly correlated
with the rate of a futures contract; - Risk of indivisibility is incurred when the number of contracts bought or sold
does not perfectly correspond to the amount to be covered.
- Covering interest rate risk in options market
Options on interest rate may be used:
- For covering against interest rate variations; in effect, purchase of a option
enables the buyer to ensure that he would not have to pay more than a certain rate
of interest on his borrowing, or would not receive less than a certain minimum
rate on his lending; - For speculations;
- For arbitrage operations.
- Mechanism of Interest Rate Options
Purchase of a call option gives a right to the holder to buy a financial asset at a fixed
price and purchase of a put option gives him a right to sell a financial asset at a fixed
price, called exercise price, on payment of a premium to the seller of the option. Interest
rate options have certain characteristics:
- Contracts are standardized from the viewpoints of amounts, maturity, and period
(March, June, September, December) : - Exercise prices are given at intervals of 0.25 dollar for Euro-dollar contracts, for
example, 92.25,92.50, 92.75 etc; - Contracts are easily negotiable;
- The clearing house ensures the regularity of operations.
- Purchase of a Put Option
A put option is also called a borrowing option. In order to cover against a rise in the
interest rate, an operator (for example, an enterprise that has to borrow shortly by issuing
bonds or a portfolio manager who has to shortly liquidate his bonds) purchases put
options.
- Purchase of a Call Option
A call option is used when one fears a fall in interest rates.