Bond Options: Overview, Risks and Examples

What Is a Bond Option?

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 derivative products that allow investors to take speculative bets on the direction of underlying asset prices or to hedge certain asset risks within a portfolio.

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 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 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. Hedgers can use bond options to protect an existing bond portfolio against adverse interest rate movements. Speculators trade bond options in the hope of making profit on favorable, short-term movements in prices. Arbitrageurs use bond options to profit from option price discrepancies, or like speculators seek to identify favorable bond market mispricings.

Option Risks

Options can create a number of risks depending on an investor’s positioning so it can be important to understand the value at risk with each option contract through payoff diagrams. 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. 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. When an asset rises with a call option on it, the call holder’s gain is equal to the call seller’s loss. When an asset falls with a put option on it, the put holder’s gain is equal to the put seller’s loss. 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).

Marketable Bond Options

Unlike stocks, bond options are less easily found on secondary markets. Most bond options that do exist 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. 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. 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.)

For one example, 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. If 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. On the other hand, 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.

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. 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 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 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 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 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. 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.