Options
An option is an agreement between two parties: a seller (also called a writer) and a buyer (also called the holder), in which the buyer has the right to buy or sell a specific amount of some underlying asset under specified conditions. With a call option, the buyer purchases the right to buy an asset from the writer at a specific price before a predetermined expiration date. With a put, the buyer purchases the right to sell an asset to the writer at a specific price before a predetermined expiration date.
The amount paid for the option is the option price, or option premium. The agreed upon price for the underlying asset, should the buyer decide to exercise the option, is the strike price.
Let’s look at an interest rate option to demonstrate how an option works.
When a municipality issues a bond at a variable interest rate, it is opening itself up to interest rate risk. If interest rates go up over time, the issuer will have to pay more in interest. An issuer can hedge the forward risk of rising interest rates by buying an interest rate call option.
Say that interest rates are currently at 4% and you buy an interest rate call with a strike rate of 4.5%. Since the strike rate is higher than the current interest rate, the option would not be exercised. The difference between the market rate and the strike rate is called the intrinsic value of the option. Because the market rate is lower than strike rate, the intrinsic value is zero, and the option will not be exercised. The amount of money that the issuer will pay to purchase an option is called its premium. An option’s premium is the amount of its intrinsic value plus its time value. Because the call option in our example has an intrinsic value of $0, the price of the premium is equal to its time value. Now let’s say that interest rates rise enough that the market rate goes higher than the strike rate. The issuer can exercise the call option. The money the issuer receives from the differe