Understanding corporate finance: derivative contracts: interest rate options
Using interest rate options
A forward rate agreement (FRA) allows a company to enter into a forthcoming transaction at a guaranteed interest rate. The 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.
The facts are as in CFM13300. Cludwin Ltd wants to borrow £12 million in 6 months’ time. It knows it will have to pay a fixed rate of LIBOR plus 0.2% over the 2-year period of the loan. 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.
The 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, LIBOR has risen to 5.5%, so the company exercises the option. The option is cash settled. The bank pays Cludwin Ltd a cash sum of
(5.5% - 5.2%) x £12,000,000 x 2 years = £72,000,
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). The net effect is that the company borrows at 5.4%.
However, had 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%.