Its spinning my head - IRCs

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megamind

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The excerpt below is shaking my entire concept of Interest rate call and put options:
“In a stable interest rate environment the manager is not concerned about interest rates increasing which would decrease the value of their bond portfolio. In this type of environment they can earn additional income by entering into a covered call strategy which means they own the underlying asset, in this case bonds, and sell interest rate call options based on Treasury futures contracts. This strategy will provide income in the form of premiums earned from the sale of the call options. If interest rates decrease, the Treasury futures will increase in price and the call options will be exercised if the Treasury futures is above the strike price reducing the seller of the call options return. The covered call strategy does not protect against an increase in interest rates where bond values would decrease except for the amount of the premium earned on the sale of the call options.”
I though Interest rate call options payoff when interest rates rise, while this says opposite.
Please explain this.
Thanks already.
 
Think of the call as an option on the underlying value of the bond. If interest rates rise, the bond value falls which lowers the value of the call option.
 
Yes, but the statement clearly states int rate call options based on Tsy futures.
What happens to bond futures when rates rise……exactly…. they don’t!
 
It’s arguable that they’re saying to sell call options on treasury futures.
 
Somehow clear to me rather than ambiguous, especially as the underlying asset is stated as bonds.
If you sell (pure) interest rate call options they are usually libor based and you end up with a duration mismatch against bonds. Of course you could sell OJ calls if you were happy or ignorant to basis risk.
 
The general theme of the paragraphs speaks towards the notion of owning the underlying and writing covered calls - The only ambiguous part is “writing interest rate options” which the OP, and yourself, are taking to mean selling calls on interest rate futures and not treasury bond futures.
They’re selling treasury bond call options, not interest rate options.
 
I have said exactly that in my first post, politely suggesting that megamind needs to read the statement very carefully!
 
Then we would be in the middle of trading places with Eddie Murphy and Dan Aykroyd
 
Let me know if I summed up this discussion accurately:
“Payoff for both IRCs on LIBOR and IRCs on bond futures is based on interest rate. However, payoff for IRC on LIBOR is directly and positively related to interest rates, whereas payoff to IRC on bond futures is indirectly and inversely related to interest rates. Indirectly means that we have to look through what interest rates would do to bond futures price and then change in the futures price determines the payoff. Inversely implies that payoff to IRCs increases when interest rates decrease and vice-versa.”
 
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