What is a Bond Option?
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 Does a Bond Option Work?
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 Does a Bond Option Matter?
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.
