European bond options

Definitions Bond option: A bond option is the right to buy or sell a bond at a particular date at a particular price (the strike price X). The purchaser of an option is not obliged to buy or sell at the exercise price and will only do so if it is profitable (if the option is in-the-money). He may allow the option to lapse, in which case he loses only the initial purchase price of the option. Bond options are available in exchange -traded and over-the-counter markets. Clean price: Dirty price: the quoted price of a bond (all-in price) the cash price of a bond

Relationship between the clean price and the dirty price: Dirty price = clean price + accrued interest since last coupon date

Description An option to buy is a call option and is in-the-money if the market value of the underlying stock at the options expiry date (ST, say) is greater than the exercise price X, i.e., if ST > X. An option to buy is a put option and is in-the -money if X > ST.

In a European option the buyer can only exercise his right to take up the option or let it lapse on the expiry date, whereas with an American option this right can be exercised at any time up to the expiry date. Hence, European options are cheaper than American options.

Theory

Assume that the bond price at the maturity of the option is lognormal. Then the price of the option is given by
c = e rT [ FN ( d1 ) XN (d 2 )]

for a call, and

p = e rT [ XN ( d 2 ) FN ( d1 )]

for a put, where

F 1 ln + 2 T X 2 d1 = ; T
d 2 = d1 T .

is defined such that T is the standard deviation of the logarithm of the bond price

at the time of the options maturity. The bond forward price F = ( B I )e rT , where B is the spot bond price and I is the present value of the coupons that will be paid during the life of the option. Both B and I are cash prices, and not quoted prices.

X should be the cash strike price: If the strike price is defined as Put X equal to

the cash amount exchanged for the the strike price bond when the option is exercised the quoted price applicable when the the strike price plus accrued interest at option is exercised the options expiration date

Example Consider a 10-month European call option on a 9.75-year bond with a face value of R1 000. (At option maturity, the bond will have 8 years and 11 months remaining.) Suppose that the current cash bond price is R960, the strike price is R1 000, the 10-month risk-free

interest rate is 10% p.a., and the volatility measure for the bond price in 10 months is 9% p.a.

The bond pays a semi-annual coupon of 10% and coupon payments of R50 are expected in 3 months and 9 months. Suppose that the 3-months risk-free interest rate is 9% p.a. and the 9-months risk-free interest rate is 9.5% p.a.

Since Dirty price = clean price + accrued interest since last coupon date, Clean price = R960 R25 = R935

The present value of the coupon payments is

I = 50 e 0. 250.09 + 50 e 0. 750.095 = R 95.45

The bond forward price is F = ( B I ) e rT 10 = (960 95.45) exp 0.1 12 = R939.68

If the strike price is Put X equal to defined as the cash amount exchanged for the bond when the option is exercised the quoted price applicable when the option is exercised the strike price

Value of X

Value of c

1 000

R9.49 (1)

1 1000 + 50 6 accrued interest at the options expiration date = 1008 .33

the strike price plus

R7.97 (2)

(1)
F 1 ln + 2 T X 2 d1 = T 939 .68 1 2 10 ln + (0.09) 1000 2 12 = 10 0.09 12 = 0.7162

d 2 = d1 T = 0.7162 0.09 = 0.7983 10 12

N ( d1 ) = 0.236937; N (d 2 ) = 0.212335

c = e rT [ FN ( d1 ) XN ( d 2 )] 10 = exp 0.1 [939 .68 (0.236937 ) 1000 (0.212335 )] 12 = R9.49

(2)
F 1 ln + 2 T X 2 d1 = T 939 .68 1 2 10 ln + (0.09) 1008 .33 2 12 = 10 0.09 12 = 0.8172

d 2 = d1 T = 0.8172 0.09 = 0.8994 10 12

N ( d1 ) = 0 .206909; N ( d 2 ) = 0 .184233

c = e rT [ FN ( d1 ) XN (d 2 )] 10 = exp 0.1 [939 .68 ( 0.206909 ) 1008 .33 (0.184233 )] 12 = R7.97