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Foreign Exchange Interest Rate Option


 

Introduction

Foreign exchange interest rate option refers to a deal that option buyer is entitled to, within a specific time, purchase from option seller a certain amount of interest rate trading subjects at a price agreed upon both parties. It is a right related to an interest rate change. An option buyer acquires this right after payment of a certain amount of option fees. On the maturity date, the option buyer shall, at a pre-agreed interest rate, make a certain amount of borrowing or lending according to a certain term.

Features

Interest rate options are an effective tool to hedge short-term interest rate risk. Under a premise of paying a certain fees (option fees), an option buyer obtains a more flexible protection. When the market interest rate changes towards an unfavorable direction, the option buyer can exercise such an option to lock up interest rate risk; When the market interest rate changes towards a favorable direction, the option buyer can also choose not to exercise such an option, thus to enjoy a better market interest rate or choose a more favorable timing to lock up relevant risks. While collecting the option fees from buyers, option sellers shall bear corresponding obligations correspondingly.

Term

A specific trading period is determined on the basis of customers' needs.

Target Customers

Corporate customers with foreign exchange liabilities or on-lending, issued or not issued by Bank of China; and domestic institutions holding foreign currency assets as well as other customers approved by relevant regulatory authorities.

Process

1. Agreement signing: before conducting option trading with Bank of China, customers need to sign the Master Agreement of Derivative Transactions.

2. Deposit implementation: customers engaging in such a product must have credit supports or provide a certain amount of cash as the security deposit to the customer relations department.

3. Inquiry: customers shall inquire from Bank of China about the price by providing all the transaction details in the form of written applications.

4. Submission of transaction application: before entering into such a transaction with Bank of China, the customer needs to submit a transaction application to Bank of China.

5. Completion of the transaction: once the transaction is concluded, Bank of China shall provide transaction confirmation to the customer.

6. Settlement: the option buyer pays the corresponding seller all the option fees for one time on the value date; if such an option is exercised, both parties shall, according to the pre-agreed interest rate and a certain term, borrow or lend a certain amount of money.

Case

For example, a company may, after borrowing foreign exchange loans and in hope of retaining some flexibility, be reluctant to transfer its liabilities at a floating interest rate into fixed-rate debts. In this case, interest rate options may be a good choice. Interest rate options have many forms as follows:

1. Interest rate cap (to lock up the ceiling of a floating interest rate)

When borrowing foreign exchange loans at a floating interest rate, a company can select to buy the interest rate cap to lock up the ceiling of the floating interest rate. Therefore, the company avoids potential risks arising from a substantial increase in the interest rate; the company's benefits still remain unaffected no matter market interest rates remain unchanged or even decrease.

2. Interest rate floor (to lower the cost of debts)

When borrowing foreign exchange loans at a floating interest rate, a company can select to sell the interest rate floor. Selling an interest rate floor is one option transaction type which may result in a sum of option fees.

3. Interest rate collar (to lock up the ceiling of a floating interest rate with low costs)

When borrowing foreign exchange loans at a floating interest rate, a company can select to buy an interest rate cap and sell an interest rate floor at the same time to off-set a part of necessary option fees with a corresponding option fee income, thus to attain the company's objective of interest rate risk avoidance and cost reduction. Therefore, the company's interest rate costs are to be locked up within an exact range from such an interest rate floor to the cap.

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