What Is a Bond Option?

What Is a Bond Option?

A bond option is a 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 options, including bond options, are derivative products that allow investors to take bets on the direction of underlying asset prices or to hedge certain asset risks within a portfolio.

Key Takeaways

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

Types of Options

Options come in two forms, call options or put options. A call option gives a holder the right to buy an underlying asset at a specific price. A put option gives the holder the right to sell an underlying asset at a specific price. Most U.S. options allow the option holder to exercise at any time up to the expiration date.

Market participants strategically use bond options in their portfolios. Hedgers use bond options to protect an existing bond portfolio against adverse interest rate movements. Speculators trade bond options in the hope of making a profit on favorable, short-term price movements. Arbitrageurs use bond options to profit from option price discrepancies or identify favorable bond market mispricings.

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 expects a decline in interest rates and an increase in bond prices. If interest rates decline, the investor may exercise his right to buy the bonds.

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. 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. 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.

There is an inverse relationship between bond prices and interest rates since prices increase when interest rates decline and vice versa.

Bond Put Option

The buyer of a bond put option expects 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 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 and sell the bond at the higher market price.

Embedded Options

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 before 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 that allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at a certain period in the future.

What Are the Risks Associated With Bond Options?

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. For all options, investors who buy either a call or put option will have a maximum loss equal to the purchase value of the option. 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.

Where Do Investors Trade Bond Options?

Unlike stocks, bond options are less easily found on secondary markets. Most bond options 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, which 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.

How Are Bond Options Priced?

There are 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.

The Bottom Line

A bond option is a contract in which the underlying asset is a bond. A call option gives a holder the right to buy the bond at a specific price. A put option gives the holder the right to sell the bond at a specific price. Like all options, the contract holder is not obligated to exercise the option.

Article Sources
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  1. University of Texas. "Bond Options, Caps, and the Black Model."

  2. University of Texas. "A Binomial Interest Rate Model and the Black-Derman-Toy Model."

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