Many governments spend in excess of tax revenue. As an alternative to hiking taxes, these governments raise funds by selling government bonds, such as U.S. Treasury bonds. Government bonds are considered risk-free because stable governments are not expected to default. These debt instruments are more popular when stocks look weak, encouraging skittish investors to seek safer options.

Another way to invest in debt instruments and government bonds is via derivatives that include futures and options. One factor posing a risk to debt instruments are interest rates. As a general rule, bond prices fall as interest rates rise, and vice versa. Options tied to interest-rate instruments such as bonds are a convenient way to hedge against fluctuating rates. Within this category, options on Treasury futures are popular because they are liquid and transparent. There are also options on cash bonds. 

Key Takeaways

  • Debt options are derivatives contracts that use bonds or other fixed-income securities as their underlying asset.
  • Calls give the holder the right, but not the obligation, to buy bonds at a pre-set price on or before their expiration date, while puts give the option to sell.
  • The most common debt options actually use bond futures as their underlying and are cash settled.
  • Debt options work hand-in-hand with interest rate options since bond prices vary inversely with changes in interest rates.

Options on Bond Futures

Options contracts provide flexibility as the purchaser is buying the right (rather than an obligation) to buy or sell the underlying instrument at a predetermined price and expiry date. The option buyer pays a premium for this right. The premium is the maximum loss the buyer will bear, while the profit is theoretically unlimited. The opposite is true for the option writer (the person who sells the option). For the option seller, the maximum profit is limited to the premium received, while losses can be unlimited.

The options buyer can purchase the right to buy (call option) or to sell (put option) the underlying futures contract. For example, a buyer of a call option for a 10-year Treasury Note is taking a long position, while the seller is taking a short position. In the case of a put option, the buyer is taking a short position, while the seller is taking a long position in the futures contract.

Debt Options Overview
  Calls Puts
Buy The right to buy a futures contract at a specified price The right to sell a futures contract at a specified price
Strategy Bullish: Anticipating rising prices/falling rates Bearish: Anticipating falling prices/rising rates
Sell Obligation to sell a futures contract at a specified price Obligation to buy a futures contract at a specified price
Strategy Bearish: Anticipating rising prices/falling rates Bearish: Anticipating falling prices/rising rates

Covered Options

An option is said to be "covered" if the option writer holds an offsetting position in the underlying commodity or futures contract. For example, a writer of a 10-year Treasury futures contract would be called covered if the seller either owns cash market T-Notes or is long the 10-year T-Note futures contract.

The seller's risk with a covered call is limited, as the obligation towards the buyer can be met either by the ownership of the futures position or the cash security tied to the underlying futures contract. In cases where the seller doesn't possess any of these to fulfill the obligation, it is called an uncovered or naked position. This is riskier than a covered call

While all terms of an option contract are predetermined or standardized, the premium paid by the buyer to the seller is determined in the marketplace and in part depends on the chosen strike price. Options on a Treasury futures contract are available in many types, and each has a different premium according to the corresponding futures position. An option contract will specify the price at which the contract can be exercised along with the expiration month. The predefined price level selected for an option contract is called its strike price or exercise price

The difference between the strike price of an option and the price at which its corresponding futures contract is trading is called the intrinsic value. A call option will have an intrinsic value when the strike price is less than the current futures price. On the other hand, a put option gains intrinsic value when its strike price is greater than the current futures price.

An option is "at the money" when the strike price is equal to the price of the underlying contract. An option is in the money when the strike price indicates a profitable trade (lower than market price for a call option, and more than market price for put options). If exercising an option means immediate loss, the option is called out of the money.

An option's premium is also dependent on its time value, that is, the possibility of any gain in intrinsic value before expiry. As a general rule, the greater the time value of an option, the higher the option premium will be. Time value decreases and decays as an option contract nears expiration.

Options on Cash Bonds

The market for options on cash bonds is smaller and less liquid than for options on Treasury futures. Traders in cash bond options don't have many convenient ways to hedge their positions and when they do it comes at a higher cost. This has diverted many towards trading cash bond options over-the-counter (OTC), as such platforms cater to the specific needs of clients, especially institutional clients like banks or hedge funds. Specifications such as strike price, expiration dates, and face value can be customized.

The Bottom Line

Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility. Among debt market derivatives, the most liquidity will be found with U.S. Treasury futures and options. These products have wide market participation from around the world through exchanges such as CME Globex.