DEFINITION of 'Bond Option'

A bond option is an option contract in which the underlying asset is a bond. Other than the different characteristics of the underlying assets, there is no significant difference between stock and bond options. Just as with other options, a bond option allows investors the ability to hedge the risk of their bond portfolios or speculate on the direction of bond prices with limited risk.

BREAKING DOWN 'Bond Option'

To understand a bond option, let’s briefly summarize the basics of options. A call option gives the buyer the right to purchase the underlying assets of the option at a specific price before the option expires. The buyer is not obligated to exercise his rights, however, the seller (or writer) of the call option is. When the buyer exercises his rights, the call writer must sell the underlying assets to him at the strike price agreed on. A put option gives the buyer the right to sell the underlying assets of the option at a specific price before the option expires. Like a call option, the writer of a put option is obligated to purchase the assets if the buyer exercises his rights to sell.

Bond Call Option

A bond option is a contract that gives an investor or issuer the right to buy or sell a bond by a particular date for a predetermined price. A buyer of a bond call option is expecting a decline in interest rates and an increase in bond prices. If interest rates decline, the issuer 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. For example, an investor purchases 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 options 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 will 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. The 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 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 before it matures to the issuer when interest rates rise.

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 future.

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; arbitrageurs use them to profit from the price differentials of similar products in different markets; and speculators trade bond options in the hope of making profit on short-term movements in prices.

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