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 bond option products that allow investors to take speculative bets on the direction of underlying asset prices or to hedge certain asset risks within a portfolio. 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 bond option 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.
On the other hand, the Black—Scholes model, which assumes constant volatility, does not reflect this processand cannot therefore be applied here;  see Black—Scholes model Valuing bond options. Addressing this, bond options are usually valued using the Black model or with a lattice-based short rate model such as Black-Derman-ToyHo-Lee or Hull—White. For American- and Bermudan- styled optionswhere exercise is permitted prior to maturity, only the lattice-based approach is applicable. Using the Black model, the spot price in the formula is not simply bond option market price of the underlying bond, rather it is the forward bond price.
Understanding Bond Options 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 put option gives the holder the right to sell an underlying asset 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.
As with all options, the contract holder is not obligated to exercise. Thus, the combination 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 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. 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.
Selling a bond call or bond put option can have unlimited risks of loss.
Marketable Bond Options Unlike bond option, bond options are less easily found on secondary markets. Most bond options that do bond option will trade over the counter. Secondary market bond options are available on U. 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.
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A secondary market buyer of a bond call option is expecting 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 prices and interest rates—prices increase when interest rates decline and vice versa. 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. Embedded Options in Bonds Bond call and put options are also used to vanilla options to the option-like features of some bond option.
The bondholder has, in effect, sold a call option to the issuer. 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. 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.