Bond option

In finance, a bond option is an OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price. It is similar to a stock option with the difference that the underlying asset is a bond. Bond options can be valued using the Black model.

The present market value for the bond is referred to as the spot price while the future value as per the option is referred to as the strike price.

Types

• A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price.

• An American Bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price.

Example

Trade Date: 1 March 2003 Maturity Date: 6 March 2006 Option Buyer: Bank A Underlying asset: FNMA Bond. Spot Price: $101 , Strike Price: $102

On the Trade Date, Bank A enters into an option with Bank B to buy certain FNMA Bonds from Bank B for the Strike Price mentioned. Bank A pays a premium to Bank B which is the premium percentage multiplied by the face value of the bonds.

At the maturity of the option, Bank A either exercises the option and buys the bonds from Bank B at the predetermined strike price, or chooses not to exercise the option. In either case, Bank A has lost the premium to Bank B.

Embedded option

The term "bond option" is also used for option-like features of some bonds. These are an inherent part of the bond, rather than a separately traded product. These options are not mutually exclusive, so a bond may have lots of options embedded.

• A callable bond allows the issuer to buy back the bond at a predetermined price at certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.

• A puttable bond allows the holder to demand early redemption at a predetermined price at certain time in future. The holder of such a bond has, in effect, purchased a put option on the bond.

• A convertible bond allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at certain time period in future.

• An exchangeable bond allows the holder to demand conversion of bonds into the stock of a different company, usually a public subsidiary of the issuer, at a predetermined price at certain time period in future.

Relationship with caps and floors

European Put options on zero coupon bonds can be seen to be equivalent to suitable caplets, i.e. interest rate cap components, whereas call options can be seen to be equivalent to suitable floorlets, i.e. components of interest rate floors. See for example Brigo and Mercurio (2001), who also discuss bond options valuation with different models.

Uses

The major advantage of a bond option is the Locking-in price of the underlying bond for future thereby reducing the credit risk associated with the fluctuations in the bond price.

References

• Damiano Brigo and Fabio Mercurio (2001). Interest Rate Models - Theory and Practice with Smile, Inflation and Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4. 

See also

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