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A bond option is a derivative contract hedging the value of a bond at a given strike price with a given expiration date.
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 and if the price had fallen, the option would be valued at a discount.
To illustrate, suppose a 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.
A put bond option is the exact opposite of a call bond option.
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 higher than the current interest rate level.
A coupon bond, frequently referred to as a bearer bond, is a bond with a certificate that has small detachable coupons. The coupons entitle the holder to interest payments from the borrower. Coupon bonds are rare today because most bonds are not issued in certificate form; rather, they are registered electronically (although some bondholders still choose to hold paper certificates). Thus, these days the term coupon refers to the rate of interest on a bond rather than the physical nature of the certificate.
In the 1980s, some financial institutions began purchasing coupon bonds and selling the coupons as separate securities, called strips.
