DEFINITION of 'Yield-Based Option'

Yield-based option is a type of option that derives its value from the difference between the exercise price (expressed as a percentage) and the yield of the underlying debt instrument. Yield-based options are settled in cash.

BREAKING DOWN 'Yield-Based Option'

A yield-based option is a contract that gives the buyer the right but not the obligation to purchase or sell the underlying debt instrument, depending on whether the buyer purchased a yield-based call or put option. A yield-based call buyer expects interest rates to go up, while a yield-based put buyer expects interest rates to go down. If the interest rate of the underlying debt security rises above the strike rate of a yield-based call option plus the option premium paid, the call holder is 'in the money'. Should the opposite occur, and the interest rate falls below the strike yield less the premium paid for a yield-based put option, the put holder is in the money. When yields increase, yield-based call premiums increase, and yield-based put options will lose value and most likely expire.

Characteristics of Yield-Based Options

There are a number of characteristics of yield-based options that are worth noting:

  • Yield-based options are European options, which means that they can only be exercised on the expiration date, compared to American options that can be exercised anytime up to the expiry date of the contract.
  • Given that these options are cash-settled, the writer of the call will simply deliver cash to the buyer that exercises the rights provided by the option. The cash amount paid is the difference in the actual yield and the strike yield.
  • The options are based on the yields of the most recently issued 13-week Treasury bills; Five-year Treasury notes; 10-year Treasury notes, and; 30-year Treasury bonds.
  • The underlying value of yield-based options depends on the interest rate; the underlying value of a contract is ten times the underlying Treasury yield. For example, if the yield on a five-year Treasury note is 3.5%, the value of the option will be $35. If the yield on a 30-year Treasury bond is 8.2%, the price to acquire the option will be $82.
  • Finally, like equity and stock index options, yield-based options have a multiplier of $100.

Calculating the Payoff of Yield-Based Options

Let’s look at an example of how yield-based options work. An investor that expects yields in the market to increase enters into a call option contract on a 13-week T-bill with a 4.5% yield. The contract is set to expire April 15th and the total premium paid for this right is $80. On the expiration date, the yield on the debt security is 4.8% and is, thus, in the money. The buyer can exercise his right to purchase the security with a 4.5% yield, after which he can then sell the bond in the open market at a 4.8% yield. The bond is profitable because there is an inverse relationship between interest rates and bond prices - a bond offering a higher interest rate will have a higher value than one selling at a lower interest rate. The seller will settle the transaction by paying the call buyer [($48 - $45) x $100] – $80 = $220.

Yield-based options can be used by investors who want to hedge against adverse movements in interest rates. For instance, an investor who wishes to hedge a portfolio of preferred stocks would buy yield-based calls to protect her portfolio against declining rates in the markets.

Difference Between Yield-Based and Interest-Rate Options

Interest-rate options are price-based, while yield options are yield-based. An investor who expects the price of Treasury bonds to rise will buy an interest-rate call and, after exercising, purchase the underlying Treasury bond. If interest rates decrease in the economy, the price of the underlying Treasury bond will increase, and the investor will exercise her call option.

Conversely, an investor who wishes to hedge a portfolio of preferred stocks would buy interest-rate puts to protect her portfolio against declining rates in the markets.

 

RELATED TERMS
  1. Interest Rate Options

    An interest rate option is a financial derivative allowing the ...
  2. Bond Option

    A bond option is an option contract in which the underlying asset ...
  3. Call On A Call

    A type of compound option in which the investor has the right ...
  4. American Option

    An option that can be exercised anytime during its life. American ...
  5. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
Related Articles
  1. Trading

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
  2. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  3. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  4. Trading

    Three Ways to Profit Using Call Options

    A brief overview of how to provide from using call options in your portfolio.
  5. Trading

    Dividends, Interest Rates and Their Effect on Stock Options

    Learn how analyzing dividends and interest rates is crucial to knowing when to exercise early.
  6. Trading

    A Newbie's Guide to Reading an Options Chain

    Learning to understand the language of options chains will help you become a more effective options trader.
  7. Investing

    What are Options Contracts?

    An explanation of options contracts, call options and put options.
RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  3. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  4. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
Hot Definitions
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  2. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  3. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  4. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  5. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
Trading Center