Use Bond Options to Hedge a Bond Portfolio:

A customer with a large bond portfolio may want to hedge against future interest rate movements. When interest rates rise, bond prices decline. According to a speech given by Vice Chairman of the Board of the Federal Reserve System Donald L. Kohn in 2010, banks increasingly use futures to hedge against the eventual likelihood of rising interest rates.

An Option on a Swap: Swaption:


A swaption, as the name implies, offers the buyer an option to purchase an interest rate swap agreement at a certain time. The buyer pays for the right to purchase the interest rate swap but isn't obligated to do so. Swaptions are options on an underlying asset swap. Swaptions create additional leverage and may be used to speculate about interest rate movements.

Interest Rate Derivatives: Exchanging Interest Payments:

A derivative contract reflects the price of an underlying security, such as an interest rate-sensitive bond. Bond prices rise when interest rates decline, and vice versa. Interest rate derivatives describe a contract between at least two parties. The parties accept an agreement to exchange interest payments. Options, swaps and futures represent different kinds of interest rate derivative contracts. Interest rate derivatives usually trade over-the-counter.

Bond Options.
A bond option is considered a "plain vanilla" derivative in the fixed-income derivatives markets. The bond option is a basic fixed-income derivative.

Like options on other securities, a buyer pays a premium for the right to buy the underlying within a certain time period. The option seller takes the opposite position: he receives a premium by selling the right to buy the underlying over the same period. The buyer believes that interest rates of the underlying will fall, just as the seller assumes that interest rates of the underlying will rise. The contract between the two parties doesn't obligate the buyer to purchase the underlying. He merely pays for the right to do so.
Interest Rate Swaps.
Interest rate swap agreements track the movements of underlying rates such as the London Interbank Offered Rate (LIBOR). The counterparties of the contract agree to exchange payments, or cash flows, during the life of the agreement. The notional amount of the contract is determined by the parties at the outset. The payments are calculating the rate of the contract against the principal amount, such as 1 million GBP at 9 percent. The contract may agree to swap a fixed rate for a fixed rate, or a floating rate for a fixed rate, or a floating rate for another floating rate. The interest rate swaps market represented $348.5 billion at mid-year 2010. The size of the market provides high liquidity to traders.
Futures contracts provide traders with the right to buy or sell the underlying security identified by the contract on a date in the future. Interest-rate sensitive securities such as U.S. Treasury securities represent the underlying. The counterparties speculate about future interest rate movements. The buyer of the contract believes that interest rates are likely to decline. Conversely, the seller of the contract predicts interest rates will rise.