To see OTC options in use, let's consider the common application of using a cap to protect against interest rates going higher on a floating rate loan.
On the screen, you can see an example where a company has agreed a five year loan at a rate of six month arrival plus 150 basis points.
They are interested in buying a cap to lock in a maximum interest rate they would pay on the loan.
The table gives us some prices for caps with different strikes.
As the cap strike increases, the premium decreases as per all call options and intuitively this makes sense here because the highest strike caps will offer reduced protection.
You'll note that the premium can be quoted upfront or in basis points per year.
The latter is calculated here as simply the premium divided by the PVO one.
Note that in practice the payment of the premium over the life of the cap may attract an extra credit charge, which we have ignored here.
For simplicity, there are two advantages to quoting the premium on a per year basis.
Firstly, it gives the buyer the opportunity to spread the cost of the cap over the life of the loan.
And secondly, it shows us the premium represented as an increase in effect borrowing cost.
For example, if the buyer were to go for the 4% cap, they could either pay 123 basis points of notional upfront or they could pay 27 basis points per year for five years.
Effectively, the price of the cap protection is raising their overall cost of borrowing by 27 basis points.
If the company did buy the 4% cap, then if your IO fixed above 4%, the caplets would produce positive payoffs and their cost of borrowing would be limited to 4% plus their 150 basis points.
Loan margin plus the premium of 27 basis points, giving an all in rate of 5.77%.
Therefore, the maximum rate they will pay on the loan is capped at 5.77%.
Note that an alternative hedge for this company would be to pay fixed on a swap at 2.65% locking in an all in fixed rate of 4.15%.
Like all option hedges, the cap offers the reassurance of a known worst case scenario, the maximum rate of 5.77%, and the ability to benefit if rates go lower, it's up to the company to judge the trade-offs between the swap and cap alternatives.
Let's now assume our hedging company bought the 4% cap and let's look at a hypothetical path which your rival could take over the life of the loan.
Note that each acts independently and is tested against Its own Euro ibel fixing.
Caplets only produce payoffs when your arrival fixes above their strike rates.
The graph on the right shows your ibel increasing to a point where caplet payoffs are produced.
The table on the left shows the combined effect of the loan interest cost, the caplet payoffs and the cap premium.
In situations where the caplets finish out of the money, that is your I fixes below 4%, then no caplet payoff is produced and the loan interest is simply your i plus 150 plus the 27 basis points annual premium.
In situations where your IO fixes above the caplet strikes, you'll notice that the effect of the caplet payoff is to net the IO components of the loan back to 4%, hence capping the loan at the previously calculated 5.77%.
We are now in a position to see the effect of the cap hedge compared to the unhedged position.
As you can see below the cap strike, the company is just paying an extra 27 basis points per year, which is the cap premium on top of their regular borrowing cost above the cap strike.
Their borrowing cost flat lines at 5.77% just as intended by the cap hedge.
This ability to benefit in one direction and be protected in the other is a hedge characteristic that can only be achieved using options.
It's paid for in the premium of course, but options give hedges the opportunity to create a more flexible hedge than linear instruments such as swaps or RAs.
Allow.
