Options on interest rate futures have the following characteristics:
- The right, but not the obligation, to buy or sell a specific commodity or financial instrument at a specified price for a specified period or on a specified date.
- When hedging, purchased options provide “insurance” against adverse price movements but offer the flexibility to benefit from favourable price movements.
- Option sellers (or writers) receive a fixed premium upfront and in return are obligated to buy or sell the underlying item at specified prices if the option is exercised against the writer. Thus, option writers are exposed to unlimited liability.
There are two types of options:
Call option: Gives the buyer the right to buy a specific number of futures contracts at a pre-determined price within a specified period of time.
Put option: Gives the buyer the right to sell the futures contracts as described above.
For example, an investor may buy December T-bond calls with a strike price of 96. If the market price of December T-bond futures increase to 100, the call enables the option holder to purchase futures at 96 for a profit of four. If the market price falls to 90, the holder is not obligated to purchase the futures contracts and loses only the premium paid for the option.
How options on interest rate futures work?
The specific commodity underlying the option is identified. As we know, the exchange traded interest rate futures are standardized.
The strike price is determined.
The exercise period is determined.
The price or option premium is then determined on the exchange floor.
The buyer of the option may exercise the option on any business day prior to expiration by giving notice to the exchange. The notice is then randomly assigned to an option seller. However, most options are closed rather than exercised.
Standard contract features – Options on US Treasury bond and US Treasury note futures
Trading unit: $100,000 face amount of a futures contract of a specified delivery month
Price quotations: In points and 64ths of a point
Daily trading limits: Three points per contract above or below the previous day’s settlement price
Strike prices: Set in integral multiples of two points per futures contract to bracket the current futures price (i.e., if the futures price is 85, the strike prices would be 80, 82, 84, 86, 88, 90).
Months traded: March, June, September and December
Last trading day: The second to last Friday of the month prior to the delivery date of the underlying futures