Bond option
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In Finance, bond option is similar to a stock option with the difference that the underlying asset is a bond.
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Bond Option Defination
An OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price.
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 OF BOND OPTION
Embedded Bond Options:
Callable Bond: A bond that allows the issuer to buy back the bond at a predetermined price at certain time in future. The holder of such a bond has 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.
Puttable Bond A bond that allows the holder to demand early redemption at a predetermined price at certain time in future. The holder of such a bond has purchased a put option on the bond.
European Bond Options: An option to buy or sell a bond at a certain date in future for a predetermined price only at the maturity of the option
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 Fee to Bank B which is the Premium percentage multiplied by the face value of the bonds.
At the maturity of the option, either Bank A exercises the option & buy the bonds from Bank B at the predetermined value or lose the Premium Fee to Bank B without the Option Exercise at the predetermined value or lose the Premium Fee to Bank B without the Option Exercise
Advantage
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.
