Exchange Traded Interest Rate Options

1Option basics for bonds

An interest rate option gives the buyer the right, but not the obligation, to buy (call) or sell (put) the underlying bond at the strike price on or before expiry. The buyer pays a premium. The seller (writer) receives the premium and must perform if the buyer exercises.

Because bond prices move opposite to yields:

• A call on a bond gains when yields fall (bond price rises).
• A put on a bond gains when yields rise (bond price falls).

Exercise style:

• A European option can be exercised only on the expiry date.
• An American option can be exercised at any time up to expiry.

Exchange-traded interest rate options in India are European.

Remember

• Buyer: right, pays premium. Seller: obligation, receives premium.
• Rates expected down → buy calls on bonds. Rates expected up → buy puts.
• Indian IR options = European.

Practise this concept (5 questions)

2Futures versus options

Futures lock in a price, removing both downside and upside. Options insure against an adverse move but keep the upside, at the cost of the premium.

Remember

• Futures = lock in. Options = insurance, at the cost of a premium.

Practise this concept (4 questions)

3Moneyness, intrinsic value and what drives the premium

For a call on a bond (S = bond price, K = strike):

• In the money (ITM): S > K
• At the money (ATM): S = K
• Out of the money (OTM): S < K

For a put, it is reversed: ITM when S < K.

Premium = intrinsic value + time value.

• Intrinsic value: call = max(S − K, 0); put = max(K − S, 0).
• Time value: premium − intrinsic value. It is highest for ATM options and falls to zero at expiry.

Example A bond trades at ₹101.50. A call with a strike of ₹100.75 trades at a premium of ₹1.10. Intrinsic value = ₹0.75; time value = ₹0.35.

What moves an option's price:

Coupons paid on the underlying bond during the option's life lower its price, which reduces call values and increases put values.

Remember

• Premium = intrinsic + time value.
• Higher volatility raises both call and put premiums.

Practise this concept (10 questions)

4Pricing models and implied volatility

• The Black-Scholes model is widely known but assumes constant volatility and a lognormal price. Bond prices do not behave like that, because a bond's price is pulled towards par as maturity approaches, so its volatility falls over time.
• Black's model (a variation of Black-Scholes) is commonly used for options on bond futures and for caps and floors.
• Binomial / term structure (yield curve) models build a tree of possible future interest rates and price the option consistently with today's yield curve. They are better suited to bond options and to American-style exercise.

Implied volatility (IV) is the volatility that, when put into a pricing model, gives the option's current market premium. It is the market's view of future volatility. Higher IV means more expensive options. Traders compare IV with their own forecast of volatility to judge whether options are cheap or dear.

Remember

• Pull to par: bond volatility shrinks near maturity, a weakness of Black-Scholes for bonds.
• IV is worked backwards from the market premium.

Practise this concept (5 questions)

5Payoffs

Exchange-traded contracts are on ₹2 lakh face value (2,000 bonds), so multiply per-bond results by 2,000.

Example You buy a put with a strike of ₹100 for ₹0.80 (1 lot). Yields rise and the bond settles at ₹98.50. Payoff = (100 − 98.50) − 0.80 = ₹0.70 per bond × 2,000 = ₹1,400 profit. If the bond had settled at ₹101, you would lose only the premium: 0.80 × 2,000 = ₹1,600.

Remember

• Buyer's maximum loss = premium.
• Call breakeven = strike + premium; put breakeven = strike − premium.

Practise this concept (6 questions)

6Indian contract specifications, advantages and limitations

On NSE, interest rate options on Government of India securities have these typical features:

• Underlying: a specified Government of India security.
• Type: European, premium-style calls and puts.
• Contract size: ₹2 lakh face value (2,000 bonds).
• Premium tick size: ₹0.0025. Strike interval: ₹0.25.
• At least 8 in-the-money, 8 out-of-the-money and 1 near-the-money strikes are available.
• Cycle and expiry: as for interest rate futures (three serial monthly plus three quarterly contracts; last Thursday of the month).
• Settlement: cash. The final settlement price is the weighted average price of the underlying bond on NDS-OM in the last two hours of trading on expiry day.

Advantages over OTC options: standardisation, on-screen price transparency, the clearing corporation's guarantee, and access for smaller participants.

Limitations: liquidity is often thin, especially away from the money and in later months. Options are harder to price and understand than futures. The premium is a real cost if rates do not move. Standard strikes and dates may not match the exposure.

Remember

• European, cash-settled, ₹2 lakh lots, strike interval ₹0.25.
• Main limitation in practice: thin liquidity.

Practise this concept (4 questions)