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Over-The-Counter Interest Rate Options Over-the-counter interest rate options By Richhild Moessner of the Bank’s Gilt-edged and Money Markets Division. The Bank of England’s Monetary Policy Committee uses market expectations of future interest rates to inform its policy decisions. Interest rate expectations can be inferred from a range of financial instruments, including interest rate options. This article surveys the structure and use of the over-the-counter (OTC) interest rate option market.(1) It discusses what information OTC interest rate options may contain about market interest rate expectations, additional to that available from products traded on exchanges. It also considers the linkages between OTC interest rate option markets and the markets in the underlying assets. Options are financial instruments that are linked to an products traded in the OTC market. The article begins underlying asset, and whose payoffs depend on with an introduction to derivatives and interest rate movements in the price of that underlying asset. options. The differences in the sizes and other features Because of the asymmetric nature of their payoff profile, of OTC and exchange-traded derivative markets are options provide information about the probability discussed. Later sections, which are based partly on distribution of market participants’ expectations of the information from market participants, consider the main price of the underlying asset. The Bank of England uses applications of interest rate options, the usefulness of options to derive indicators of uncertainty about future OTC interest rate options for inferring sterling interest interest rates, exchange rates and equity markets, in rate expectations, and the relationship of the interest order to inform monetary policy and to identify rate option markets with the markets of the underlying potential financial stability risks.(2) For example, the assets, such as government bonds and swaps. A glossary Inflation Report uses exchange-traded option prices to of terms is provided on page 181. derive the probability distribution of market expectations of UK short-term interest rates. Introduction to derivatives and basic concepts A ‘derivative’ is a financial contract whose value depends The Bank has made relatively little use, however, of the on the future value of one or more underlying asset. information available from interest rate options that are Originally, the underlying assets were commodities, such traded in the OTC market. The OTC market contains a as cotton and rice, but many different financial range of financial products not traded on exchanges. instruments are now used, including interest rates, However, less information is publicly available about exchange rates, equities and commodities. Derivatives OTC markets than about exchange-traded markets. allow the contract holders to expose themselves to price So discussions with market participants are particularly changes in the underlying asset without having to important in gaining an understanding of the market purchase the asset. There are two main types of structure and the use of OTC interest rate options, the derivative instrument: information content of their prices, and their interrelationships with other financial markets. G Outright contracts: These are instruments with a linear payoff profile, ie they provide symmetric This article discusses the information that OTC interest payoffs to upward and downward movements in the rate options may contain, additional to that available price of the underlying contract. Examples of from exchange-traded products, given the wider range of such derivatives include interest rate futures, (1) This article is based partly on interviews with staff from Barclays Capital, the Chase Manhattan Bank, Credit Suisse First Boston, Goldman Sachs, JP Morgan, the Royal Bank of Scotland, Tullett & Spuetz Capital Markets AG, UBS Warburg, and Westdeutsche Landesbank. Full details of this study are given in Moessner (2001), available at www.bankofengland.co.uk/ccbs/publication/otcoptions.htm (2) See Clews, Panigirtzoglou and Proudman (2000), and Bank of England (2000). 172 OTC interest rate options forward-rate agreements (FRAs), and interest rate The price of an option is sensitive to the dispersion of swaps (see the glossary on page 181). expected future prices of the underlying contract, since options have an asymmetric payoff profile. Call options G Options: These are instruments with a non-linear are more expensive the greater the dispersion of future payoff profile. They provide payoffs that depend prices expected by the market, ie the greater the asymmetrically on changes in the price of the uncertainty. This is because greater uncertainty underlying contract. increases the probability that the price of the underlying contract will move further above or below the strike Many derivatives are either pure outright contracts or price at the expiry of the option, leading to a greater pure options contracts, but there are also a large payoff to the holder, while the loss to the holder is still number of more complex derivatives that are a limited to the option premium. Similarly, options are combination. cheaper when the market is more sure about future outcomes. Interest rate options therefore provide Interest rate options are option contracts that settle valuable information about the distribution of future against interest-bearing securities such as money market interest rates expected by market participants. interest rate futures, interest rate swaps and government bonds. A ‘call option’ gives the buyer the right, but not OTC and exchange-traded derivatives the obligation, to buy an underlying interest rate contract at a point in the future at a pre-determined Derivatives contracts can be traded on organised price (the ‘strike price’). ‘Put options’ give the right to exchanges or in over-the-counter markets. OTC interest sell the underlying contract. Options can be traded at a rate options can be tailored to a user’s specific variety of strike prices, which may be at-the-money requirements, since they are direct contracts between (ATM), out-of-the-money (OTM), and in-the-money counterparties without an exchange acting as an (ITM). intermediary. The main advantage of OTC contracts is therefore their greater variety and flexibility (see the Interest rate options can be divided roughly into the table overleaf). The greater variety is also a following categories: plain vanilla options, exotic disadvantage, however, since as a consequence individual options, and structured products. Plain vanilla options OTC interest rate options contracts tend to be less use standardised contracts and market conventions, and liquid than the more standardised exchange-traded are traded in generally liquid markets. The main kinds contracts. The main disadvantage of OTC contracts is of ‘plain vanilla’ OTC interest rate options are interest that they involve greater counterparty credit risk than rate caps, floors and swaptions (see the box on exchange-traded contracts. pages 176–77). Exotic options are more complex contracts; and structured products are made up of The main kinds of outright OTC interest rate derivatives several components, including outright derivative are interest rate swaps and FRAs. Interest rate options contracts, options, and the underlying contracts, such as traded in the OTC market comprise a wider range of bonds. products than those traded on exchanges, and include options with much longer times to expiry, options on Information contained in option prices swaps, many kinds of exotic options, and structured A call option is valuable only if there is a chance that the products (see the box on pages 176–77). price of the underlying contract will exceed the strike price when the option is exercised. By comparing the The OTC derivatives market is almost exclusively a prices of traded options with different strike prices, it is wholesale market. End-users of OTC derivatives are for therefore possible to infer the probabilities that market the most part institutional investors, corporate participants attach to various levels of the price of the treasurers (especially of large or multinational underlying contract.(1) Interest rate option prices can be companies), governments, and other professionals. used to infer so-called ‘implied volatilities’ (see the Providers of OTC products are mainly banks and glossary on page 181), which provide a measure of securities houses. Brokers also play an important role in market participants’ uncertainty about future interest OTC derivative markets, acting as agents between the rate movements. potential counterparties. (1) See Clews, Panigirtzoglou and Proudman (2000). 173 Bank of England Quarterly Bulletin: Summer 2001 Exchange-traded and OTC derivatives Exchange-traded OTC Trading Central market place. Trading under defined rules Direct contracts between counterparties, often via brokers. practices and regulations. Access is only via exchange members. Transparency Exchanges provide continually updated information about Very little publicly available information about the prices of recently prices and volumes of contracts traded. agreed contracts. Indicative prices are often posted on brokers’ screens. Credit risk Minimal credit risk since the exchange clearing house Counterparty credit risk is an important consideration. Margins, regular acts as the counterparty to all trades. Most exchanges revaluation and posting of collateral can be agreed, but are not obligatory. insist on initial margin
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