Interest rate options (IRO)
Interest rate options create predictability and flexibility and are an alternative to interest rate hedging.
What is an interest rate option (IRO)?
An IRO gives you the right, but not the obligation, to utilise a specific interest rate in the future. For example, if you buy a call option, also known as an interest rate cap, you have flexible protection against an increase in underlying interest rates. You can also choose not to use the IRO and thereby stick to the market rate. In other words, there is no obligation to trade at this price in contrast to trading with FRAs.
An IRO can be described as an insurance policy against unwanted changes in interest rates. If you fear that the Norwegian NIBOR interest rate will increase, you can buy an IRO. The IRO gives you access to a predetermined interest rate, which in the long term may be lower than the market rate. If the market rate drops, you don’t need to use the IRO and can use the more advantageous interest rate.
When borrowing, a maximum interest rate can be agreed
If your business fears an increase in interest rates, we can remove the risk by entering into an IRO agreement with an upper rate limit on your variable rate loan. This limit is called a Cap. This means that the company can pay the market rate as long as it’s below the Cap, but if the market rate rises above the Cap, you can choose the fixed rate instead.
For investments, a minimum interest rate can be agreed
A company that wishes to invest its money can benefit from buying an IRO that secures a minimum return on its investment. This is called a Floor. In this case, the company protects itself against the market rate falling below a certain level, while still being able to benefit from rising market rates.
Some companies want both a Floor and a Cap
It is possible to buy an IRO that has both a Floor and a Cap, and this is called a Collar. A Collar involves the company buying an Interest rate option with a Cap and selling an option with a Floor. The purpose of this is to hedge against the market rate exceeding the Cap, while being able to waive market rates below the Floor. In practice, this means that the interest rate will follow the market rate, but with an upper limit and a lower limit. The benefit of a Collar is a lower option premium, but the drawback is that the company cannot benefit from rates that fall below the Floor.
Option premium – the price of predictability
Companies that buy an IRO must pay an option premium. This is set on the basis of various factors, such as expectations in the market, the duration of the option period and the current interest rate level. In DNB Markets we offer Interest rate options in most currencies, including Norwegian kroner, for periods of up to ten years. An IRO is an attractive alternative for ensuring sound risk management.
Would you like to learn more about fixed-income securities and currency hedging?
DNB markets offers corporate clients a variety of methods for hedging and eliminating currency risk. Contact us to find the right method for your business. We also offer courses and training in handling commodities, interest rates and currency risk.
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