Interest Rate Call Option Explained (2025): Pricing, Mechanics & Real-World Example

Adam Hayes, Ph.D., CFA, brings over 15 years of Wall Street expertise as a derivatives trader, specializing in economics and behavioral finance. Holding advanced degrees and multiple certifications, including CFA and FINRA licenses, Adam currently teaches economic sociology and the social studies of finance at Hebrew University in Jerusalem.

What Is an Interest Rate Call Option?

An interest rate call option is a financial derivative granting its holder the right — but not the obligation — to receive payments based on a variable interest rate while making payments at a fixed rate. Upon exercise, the seller of the call option pays the net difference to the option holder.

Key Highlights

• Interest rate call options offer the right to pay fixed interest and receive floating interest over a set period.
• They serve as counterparts to interest rate put options.
• Financial institutions often use them to secure lending rates and manage risk.
• Investors utilize these options to hedge loans with floating interest rates.

How Do Interest Rate Call Options Work?

Understanding these options requires grasping the inverse relationship between interest rates and bond prices: when interest rates rise, bond prices fall, and vice versa. Investors and institutions use interest rate options to protect against adverse interest rate movements or to speculate.

The underlying asset is typically an interest rate benchmark, such as the 3-month Treasury bill yield or 3-month LIBOR. An investor anticipating a rise in interest rates will buy an interest rate call option, gaining the right to benefit if rates increase beyond a specified strike rate.

The option’s value at expiration depends on the difference between the market rate and the strike rate, adjusted for the contract's notional principal and the relevant time period.

Practical Example of an Interest Rate Call Option

Imagine an investor holds a long interest rate call option on a 180-day Treasury bill with a $1 million notional principal and a strike rate of 1.98%. If the market rate climbs to 2.2%, the investor exercises the option:

Payoff = (2.2% - 1.98%) × (180/360) × $1,000,000 = 0.22% × 0.5 × $1,000,000 = $1,100

Payments are settled at the end of the underlying period, so if the option expires earlier, the payoff is discounted to present value accordingly.

Advantages of Using Interest Rate Call Options

Lenders use these options to lock in minimum lending rates, protecting against rising interest rates when lending to corporations or other borrowers. Investors hedge floating-rate loan exposure, capping maximum interest payments while benefiting from rate declines.

These options can be structured for periodic or balloon payments and are traded both on exchanges and over-the-counter (OTC), offering flexibility for diverse financial strategies.

Quick Insight

A balloon payment is a large lump sum paid at the end of a loan term.

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