Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bond Option

What it is:

A bond option is a derivative contract that allows investors to buy or sell a particular bond with a given expiration date for a particular price (strike price). 

How it works (Example):

For example, a call bond option hedges that the value of a bond will increase at a future date. If the price of the underlying bond is higher than the strike price, the bond option is valued at a premium. If the price had fallen, the option would be valued at a discount. The exact opposite would be true for a put bond option.

To illustrate, suppose a call bond option has a strike price, or when the option can be exercised, of $1,000. Prior to expiration, the underlying bond reaches a market value of $1,100. This results in an increase in the market value of the bond option. Conversely, had the market price of the underlying bond dropped to $900, the market value of the bond option would also have dropped.
 

Why it Matters:

Bond options provide investors with a tool for hedging interest rate fluctuations. For instance, an investor who believes that interest rates are going to drop in the future may purchase a call bond option on an underlying bond for which the yield is higher than the current interest rate level.