Chapter 11
Options, Caps, Floors, and More Complex Swaps
Chapter Objectives
1. Introduce the characteristics of options on financial futures.
2. Demonstrate how banks can use call and put options on financial futures to manage interest rate risk.
3. Provide applications of options on financial futures for microhedging and macrohedging purposes.
4. Demonstrate how interest rate caps, floors, and collars can be used to convert loans from fixed to floating
rates,
convert fixed deposit rates to floating deposit rates, and to generally manage interest rate risk.
5. Introduce the features of interest rate swaps with call options and put options.
6. Provide an application of how a firm can use interest rate swaps with options to reduce borrowing costs.
Key Concepts
1. A call option gives the buyer the right to buy a fixed amount of the underlying asset at a specific strike price
for a set period of time.
2. A put option gives the buyer the right to sell a fixed amount of the underlying asset at a specific strike price for
a set period of time.
3. A bank that buys a call option on Eurodollar futures gains when the price of the underlying futures contract
increases, that is, when the underlying futures rate decreases. Banks thus buy call options as a hedge against
falling interest rates.
4. A bank that buys a put option on Eurodollar futures gains when the price of the underlying futures contract
decreases, that is, when the underlying futures rate increases. Banks thus buy put options as a hedge against
rising interest rates.
5. The buyer of a call option or a put option pays a premium for the option. The premium represents the entire
cost of the position as there is no margin requirement and the buyer can lose no more than the initial premium.
One attraction to the purchase of either a call or put option is that the buyer knows the maximum potential loss,
or cash outflow. Buying these options when used to offset interest rate risk elsewhere is like buying insurance. In
contrast, the sale of an option has unlimited loss potential.
6. The purchase of a put option effectively places a cap on a bank's borrowing cost. The bank can reduce the cost
of the cap by simultaneously selling a call option. The premium received from the sale of the call option reduces
the cash outlay on the put, but also sets a floor on the bank's borrowing cost. Brokers attempt to get banks to buy
collars or reverse collars as a way to lower the upfront premium cost. Of course, the banks give up most of the
positive outcome were rates to move in a favorable direction.
7. A bank that buys a call option or put option as a hedge, generally prefers that the option expire worthless. In
this situation, the bank normally gains in the cash market such that the option has no value at expiration. As such,
gains in the cash market potentially exceed the premium cost of the long option position.
8. The buyer of an option can exit the position by i) exercising the option and forcing the seller to perform, ii)
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 Spring '09
 William
 Derivatives, Derivative, Interest Rates, Interest rate swap

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