what do interest rate options tell you 
as with equity options an interest rate option has a premium attached to it or a cost to enter into the contract a call option gives the holder the right but not the obligation to benefit from rising interest rates the investor holding the call option earns a profit if at the expiry of the option interest rates have risen and are trading at a rate that s higher than the strike price and high enough to cover the premium paid to enter the contract conversely an interest rate put gives the holder the right but not the obligation to benefit from falling interest rates if interest rates fall lower than the strike price and low enough to cover the premium paid the option is profitable or in the money the option values are 10x the underlying treasury yield for that contract a treasury that has a 6 yield would have an underlying option value of 60 in the options market when treasury rates move or change so do the underlying values of their options if the 6 yield for a treasury rose to 6 5 the underlying option would increase from 60 to 65 12aside from outright speculation on the direction of interest rates interest rate options are also used by portfolio managers and institutions to hedge interest rate risk interest rate options can be entered into using short term and long term yields or what s commonly referred to as the yield curve which refers to the slope of the yields for treasuries over time if short term treasuries like the two year treasury have lower yields than long term treasuries like the 30 year yield the yield curve is upward sloping if long term yields are lower than short term yields the curve is said to be downward sloping interest rate options trade formally through the cme group one of the largest futures and options exchanges in the world regulation of these options is managed by the securities and exchange commission sec an investor may use options on treasury bonds and notes and eurodollar futures 3interest rate options have european style exercise provisions which means the holder can only exercise their options at expiration the limitation of option exercise simplifies their usage as it eliminates the risk of early buying or selling of the option contract the rate option strike values are yields not units of price also no delivery of securities is involved instead interest rate options are cash settled which is the difference between the exercise strike price of the option and the exercise settlement value determined by the prevailing spot yield 42example of an interest rate optionif an investor wants to speculate on rising interest rates they could buy a call option on the 30 year treasury with a strike price 60 and an expiration date of august 31 the premium for the call option is 1 50 per contract in the options market the 1 50 is multiplied by 100 so that the cost for one contract would be 150 and two call option contracts would cost 300 the premium is important because the investor must make enough money to cover the premium if yields rise by august 31 and the option is worth 68 at expiry the investor would earn the difference of 8 or 800 based on the multiplier of 100 if the investor had originally bought one contract the net profit would be 650 or 800 minus the 150 premium paid to enter into the call option 5conversely if yields were lower on august 31 and the call option was now worth 55 the option would expire worthless and the investor would lose the 150 premium paid for the one contract for an option that expires worthless it s said to be out of the money in other words its value would be zero and the buyer of the option loses the entire premium paid as with other options the holder does not have to wait until expiration to close the position all the holder needs to do is sell the option back in the open market for an options seller closing the position before expiration requires the purchase of an equivalent option with the same strike and expiration however there can be a gain or loss on unwinding the transaction which is the difference between the premium originally paid for the option and the premium received from the unwinding contract the difference between interest rate options and binary optionsa binary option is a derivative financial product with a fixed or maximum payout if the option expires in the money or the trader loses the amount they invested in the option if the option expires out of the money the success of a binary option is thus based on a yes or no proposition hence binary binary options have an expiry date or time at the time of expiry the price of the underlying asset must be on the correct side of the strike price based on the trade taken in order for the trader to make a profit 6an interest rate option is often called a bond option and can be confused with binary options however interest rate options have different characteristics and payout structures than binary options limitations of interest rate optionssince interest rate options are european based options they can t be exercised early like american style options however the contract can be unwound by entering into an offsetting contract but that s not the same as exercising the option investors must have a sound grasp of the bond market when investing in interest rate options treasury and bond yields have a fixed rate attached to them and treasury yields move inversely to bond prices as yields rise bond prices fall because existing bondholders sell their previously purchased bonds since their bonds have a lower paying yield than the current market in other words in a rising rate market existing bondholders don t want to hold their lower yielding bonds to maturity instead they sell their bonds and wait to buy higher yielding bonds in the future as a result when rates rise bond prices fall because of a sell off in the bond market 7