Strategies

A  A  A     

Interest Rate Option Strategies

For the sake of simplicity, taxes, commissions and other trading costs have been omitted from the discussions and strategies in this discussion; these should be taken into account when making your investment decisions. The strategies are based on hypothetical situations and should only be considered as examples of potential trading approaches.



Investor Expects Long-term Rates to Rise Reducing the Value of a Fixed-income Portfolio

Strategy - Buy TYX calls to offset the decline in value of a fixed-income portfolio.

Forecast: Investor expects rising long-term interest rates.

Objective: To offset a decline in the value of a long-term bond portfolio.

Strategy: Buy TYX calls.

Recall that option prices move directly with interest rates. When 30-year rates rise, TYX increases and calls tend to increase in value while puts tend to decrease in value. Thus, yield-based calls are used to protect or insure the value of a bond portfolio against rising interest rates (when the value of the bonds would decline.) By purchasing yield-based calls, investments can be protected against large losses without sacrficing participation in portfolio appreciation. However, remember that any portfolio appreciation may be diminished by the cost of the call options. An investor holds a portfolio of Treasury securities with a current market value of $100,000. Its weighted average coupon is 6.50% and its weighted average maturity is 20 years. The yield-to-maturity on the portfolio is 6.10%.

Because of mounting inflationary pressure in the economy, the investor anticipates a 1% rise in interest rates over the next three months. The 30-year Treasury yield is at 6.25%, and TYX at 62.50. To protect the value of his investments while continuing to earn interest income on the bonds in his portfolio, the investor decides to buy at-the-money TYX 62.50 three-month call options at a price of 1.50.

To calculate how many options are needed to protect the bond portfolio, the following two-step procedure is needed;

  • (A) First, determine by how much your portfolio will decline in value if interest rates were to rise by 1%. A financial measure known as modified duration provides the answer. Modified duration is a measure of a bond or a portfolio's price sensitivity to changes in yield. It gives you an estimated percentage change in the value of your bond portfolio for a 1% change in interest rates. The calculation is complex, but is now available on most modern financial calculators. If you are unable to calculate duration, consult your financial advisor.

    Assume that modified duration given the current value of the yield, maturity and coupon of the bonds in your portfolio is 11 years. This means that a 1% increase in interest rates will lead to a 11% decline in the portfolio value. Given a current portfolio value of $100,000, an 11% decline would mean a loss of $11,000 resulting in a new portfolio market value of $89,000.

  • (B) Determine by how much your long at-the-money TYX 62.5 calls will increase in value following a 1% rise in interest rates. A 1% percent rise in the 30-year yield from 6.25% to 7.25% results in a new value for TYX of 72.50, an increase of 10 points. Therefore, each call with a 62.50 strike will be worth 10 points if the interest rate does rise to 7.25% at expiration. Each call will be worth $1,000 (10 points x $100 multiplier). The portfolio would decline $ 11,000; therefore, 11 calls would have to be purchased. This would not be a total hedge because a premium would have been paid for the calls.

For this example, an investor will purchase 11, three-month 62.50 calls at 1.50. These calls will cost $1,650 (1.50 premium x $100 (multiplier x 11 calls). The breakeven on this position is 64, the 62.50 strike price plus 1.50 call premium. At or above 6.4% interest rate (the breakeven level) the call holder should begin to make money to offset some of the loss in the bond portfolio.

Settlement Value at Anticipated Level (72.50):
The holder would exercise his calls and receive the difference between the strike price and the settlement value. The profit would be the difference less the premium paid. This money would be used to offset some of the loss in the bond portfolio.

  • Settlement Value: 72.50
  • Less Strike Price: -62.50
  • Difference: 10
  • Amount Paid to Holder(10 x $100 x 11 contracts): $ 11,000
  • Less Cost of Calls:-1,650
  • Profit: $9,350

The profit on the option trade is applied to the bond portfolio to offset some of the loss which would occur when interest rates rose.

Settlement Value Above Breakeven (64):
If the 30-year Treasury bond yields do rise and the settlement value for TYX is at 68 at expiration (interest rates at 6.8%), the TYX 62.50 call option would be exercised, the holder of the calls would receive the amount by which the closing yield exceeds the strike price. This money would partially offset the loss in the bond portfolio due to an increase in interest rates.

  • Settlement Value: 68
  • Less Strike Price: -62.50
  • Difference: 5.50
  • Amount Paid to Holder(5.50 x $100 x 11 contracts): $6,050
  • Less Cost of Calls: -1.650
  • Profit: $4,400

Settlement Value Between Call Strike Price (62.50) and Breakeven Level (64):
If by expiration the 30-year Treasury yields do slightly increase to 6.35 which equals a settlement value of 63.5, the holder would exercise his options. He would receive the amount by which the settlement value is above the strike price. The amount received would be less than what was originally paid, but it would offset some of the cost. The value of the bond portfolio should have only dropped slightly.

  • Settlement Value: 63.50
  • Less Strike Price: -62.50
  • Difference: 1
  • Cost of Calls: $1,650
  • Less Amount Paid to Holder(1x$100x 11 calls):-1,100
  • Loss: 550

Settlement Value At or Below Call Strike Price (62.50):
If the settlement value is at or below 62.50, the yield on the 30-year Treasury is at or below 6.25%, the holder would have lost the total premium of $1,650, in this example. However, no matter how low interest rates decline, the most that the option can lose is the premium paid.

Risks In Tracking
This example assumes that the yield of your bond fund moves one-for-one with the 30-year Treasury bond yield. The risk in the combined position (bond portfolio and calls) is that an increase in the interest rate driving the bond portfolio is not offset by an equivalent increase in the 30-year Treasury bond yield.

Under these circumstances, the gains in the option position may not offset the losses in the bond position. The maximum loss in the combined position could equal the entire premium plus the loss in the bond investment.

Conversely, this "tracking error" can result in a profit if the underlying increases more than the yield driving your investment. The greater the similarity between the characteristics of your investment and long-term Treasuries, the more closely the two yields are likely to track one another.