Bond option

In finance, a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. These instruments are typically traded OTC.

  • 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.

Generally, one buys a call option on the bond if one believes that interest rates will fall, causing an increase in bond prices. Likewise, one buys the put option if one believes that interest rates will rise. One result of trading in a bond option, is that the price of the underlying bond is "locked in" for the term of the contract, thereby reducing the credit risk associated with fluctuations in the bond price.

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