14/12/2019 Bond Option Definition

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OPTIONS & DERIVATIVES TRADING OPTIONS TRADING STRATEGY & EDUCATION

Bond Option
REVIEWED BY JAMES CHEN | Updated Sep 12, 2019

TABLE OF CONTENTS
What Is a Bond Option?
Understanding Bond Options
Option Risks
Marketable Bond Options
EXPAND +
Bond Call Option

What Is a Bond Option?

A bond option is an option contract in which the underlying asset is a bond. Like all standard
option contracts, an investor can take many speculative positions through either bond call
or bond put options. In general, all types of options, including bond options, are derivative
products that allow investors to take speculative bets on the direction of underlying asset
prices or to hedge certain asset risks within a portfolio.

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KEY TAKEAWAYS
A bond option is an option contract with a bond as the underlying asset.
Individuals can buy or sell some bond call or bond put options in the secondary
market though bond option derivatives are much more limited in scope than stock
or other types of options contracts.
Bond issuers also incorporate bond call or bond put options into bond contract
provisions.

Understanding Bond Options

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To understand bond options, it is helpful to first understand some options basics. Options
come in two forms, either call options or put options. A call option gives a holder the right to
buy anPART
underlying
OF
asset at a specific price. A put option gives the holder the right to sell an
Options
underlying assetTrading Guide
at a specific price. Most options will be American which allows the option
holder to exercise at any time up to the expiration date. European options do exist which
require that an investor exercise only on the expiration date.

Market participants use bond options to obtain various results for their
portfolios. Hedgers can use bond options to protect an existing bond portfolio against
adverse interest rate movements. Speculators trade bond options in the hope of making
profit on favorable, short-term movements in prices. Arbitrageurs use bond options to profit
from option price discrepancies, or like speculators seek to identify favorable bond market
mispricings.

Option Risks
Options can create a number of risks depending on an investor’s positioning so it can be
important to understand the value at risk with each option contract through payoff
diagrams. As with all options, the contract holder is not obligated to exercise. However, non-
exercise will result in a loss of the contract’s purchase value and fees. Thus, the combination

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of the purchase value and fees create the breakeven level on an option. For all options,
investors who buy either a call or put option will have a maximum loss equal to the purchase
value of theOF
PART option.
Options Trading Guide
Selling a call or put option creates unlimited loss potential. The seller of an option is
obligated to fulfill his position when the contract holder exercises. Therefore, the buyer and
seller hope for two entirely different outcomes. When an asset rises with a call option on it,
the call holder’s gain is equal to the call seller’s loss. When an asset falls with a put option on
it, the put holder’s gain is equal to the put seller’s loss. Call options have unlimited potential
for gain by the buyer when an asset price rises and unlimited potential for loss by the seller
who must deliver the security. With a put option, the buyer could gain the full value of the
underlying asset if its value falls to zero, making the full value at risk to the seller (excluding
fees).

Important: Selling a bond call or bond put option can have unlimited risks of
loss.

Marketable Bond Options

Unlike stocks, bond options are less easily found on secondary markets. Most bond options
that do exist will trade over the counter. Secondary market bond options are available on
U.S. Treasury bonds. Beyond that, investors must look to options on bond exchange-traded
funds (ETFs).

Many bond options are embedded. This means they come with a bond and can be exercised
at the request of either the issuer or investor depending on the embedded bond option
provision.

Bond Call Option

A bond call option is a contract that gives the holder the right to buy a bond by a particular
date for a predetermined price. A secondary market buyer of a bond call option is expecting
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a decline in interest rates and an increase in bond prices. If interest rates decline, the
investor may exercise his rights to buy the bonds. (Remember there is an inverse relationship
between bond
PART OF prices and interest rates—prices increase when interest rates decline and vice
versa.)Options Trading Guide

For one example, consider an investor who buys a bond call option with a strike price of
$950. The par value of the underlying bond security is $1,000. If over the term of the contract,
interest rates decrease, pushing the value of the bond up to $1,050, the option holder will
exercise his right to purchase the bond for $950. On the other hand, if interest rates had
increased instead, pushing down the bond’s value below the strike price, the buyer would
likely choose to let the bond option expire.

Bond Put Option

The buyer of a bond put option is expecting an increase in interest rates and a decrease in
bond prices. A put option gives the buyer the right to sell a bond at the strike price of the
contract. For example, an investor purchases a bond put option with a strike price of $950.
The par value of the underlying bond security is $1,000. If as expected, interest rates increase
and the bond’s price falls to $930, the put buyer will exercise his right to sell his bond at the
$950 strike price. If an economic event occurs in which rates decrease and prices rise past
$950, the bond put option holder will let the contract expire given that he is better off selling
the bond at the higher market price.

Embedded Options in Bonds

Bond call and put options are also used to refer to the option-like features of some bonds.
A callable bond has an embedded call option that gives the issuer the right to “call” or buy
back its existing bonds prior to maturity when interest rates decline. The bondholder has, in
effect, sold a call option to the issuer. A puttable bond has a put option that gives
bondholders the right to “put” or sell the bond back to the issuer at a specified price before
it matures.

Another bond with an embedded option is the convertible bond. A convertible bond has an
option which allows the holder to demand conversion of bonds into the stock of the issuer at
a predetermined price at a certain time period in the future.

Bond Option Pricing

There are approximately two top models used in pricing bond options. These models
include the Black-Derman-Toy Model and the Black Model. The variables used in both are
primarily the same. The key variables involved in bond option pricing will include the spot
price, forward price, volatility, time to expiration, and interest rates.

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Related Terms
PART OF
HowOptions
a Put Works
Trading Guide
A put is an options contract giving the owner the right, but not the obligation, to sell the underlying
asset at a specific price in a specific time. more

How Options Work for Buyers and Sellers

Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a
stated price within a specified period. more

How Interest Rate Options Work, and How Investors Can Profit from
Them
An interest rate option is a financial derivative allowing the holder to hedge or speculate on changes
in interest rates at various maturities. more

How Interest Rate Call Options Work

An interest rate derivative where the holder has the right to receive an interest payment based on a
variable interest rate and, subsequently, pays a fixed interest rate. more

American Options Allow Investors to Exercise Early to Capture

Dividends
An American option is an option contract that allows holders to exercise the option at any time prior
to and including its expiration date. more

How European Options Work

A European option can only be exercised on its maturity date, not before like an American option
resulting in a lower premium for European options. more

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