Interest Rate Options and Trading Volatility

Options are an important class of products in most financial markets, and fixed income is no exception. An understanding of options allows a trader to use a wider set of tools to express views on the underlying rates and opens up the opportunity to trade volatility, which can provide uncorrelated returns to a rates‐trading portfolio. This chapter provides a basic introduction to options, especially in the rates world, and to the concepts underlying trading volatility. Options provide the buyer with the right, but not the obligation, to purchase or sell an asset. Due to their asymmetric nature, options add a new set of tools for investors to take views and manage risk in many markets. Interest rate options markets are some of the largest in the world and share many basic principles with options from other markets, such as equities. However, there are some big differences as well in both the way underlying rates are assumed to move and the types of options products available. Furthermore, interest rate markets are cluttered with a large set of products where options are embedded for either the issuer or investor. Generally these products are best understood as some combination of bonds and interest rate options. Finally, options offer investors the ability to trade the volatility of rates, which can provide diverse sources of return for a fixed income portfolio.