CFA Level 1 - Derivatives
- An FRA is a commitment to make one interest rate payment and receive another one at a future date while an option is the right to make one interest rate payment and receive another one.
- Interest rate options have exercise rate or strike rate instead of an exercise price like an FRA.
Payoffs for interest rate options function are similar to other options. The main difference is that the interest rate options take the days to maturity attached to the agreement into account. Also, the payoff from the option is not made until the end of the number of days attached to the rate. For example, if an interest rate option expires in 60 days and is based on 180-day LIBOR, the holder will not be paid for 180 days.
Interest rate call option payoffs are determined by the following formula:
Interest rate put option payoffs are determined by the following formula:
Note that in each of the formulas above, the result of the equation is multiplied by the notional amount.