A quick guide to debt options

Many governments spend more than tax revenues. Instead of raising taxes, these governments raise funds by selling government bonds, such as US Treasury bills. Government bonds are considered risk-free because stable governments are not expected to default. These debt securities are more popular when stocks look weak, encouraging nervous investors to seek out safer options.

Another way to invest in debt securities and government bonds is through the use of derivatives including futures and options. Interest rates are a risk factor for debt instruments. As a general rule, bond prices fall when interest rates rise, and vice versa. Options linked to interest rate instruments such as bonds are a convenient way to hedge against rate fluctuations. In this category, Treasury futures options are popular because they are liquid and transparent. There are also options on cash bonds.

Key points to remember

  • Debt options are derivative contracts that use bonds or other fixed income securities as the underlying asset.
  • Call options give the holder the right, but not the obligation, to buy bonds at a pre-determined price on or before their expiration date, while put options give the option to sell.
  • The most common debt options actually use bond futures as the underlying and are settled in cash.
  • Debt options go hand in hand with interest rate options since bond prices move inversely to changes in interest rates.

Options on bond futures

Options contracts offer flexibility because the buyer buys the right (rather than an obligation) to buy or sell the underlying instrument at a predetermined price and expiration date. The option buyer pays a premium for this right. The premium is the maximum loss the buyer will bear, while the profit is theoretically unlimited. The reverse is true for the option seller (the person selling the option). For the option seller, the maximum profit is limited to the premium received, while losses can be unlimited.

The options buyer can buy the right to buy (call option) or sell (put option) the underlying futures contract. For example, a buyer of a call option for a 10-year Treasury note takes a long position, while the seller takes a short position. In the case of a put option, the buyer takes a short position, while the seller takes a long position on the futures contract.

Overview of borrowing options
calls met
To buy The right to buy a futures contract at a specified price The right to sell a futures contract at a specified price
Strategy Bullish: Anticipating rising prices/falling rates Bearish: Anticipating falling prices/rising rates
To sell Obligation to sell a futures contract at a fixed price Obligation to buy a futures contract at a fixed price
Strategy Bearish: Anticipating rising prices/falling rates Bearish: Anticipating falling prices/rising rates

Covered Options

An option is said to be “covered” if the option writer holds an offsetting position in the underlying commodity or futures contract. For example, an issuer of a 10-year Treasury futures contract would be said to be covered if the seller holds spot market T-Notes or is long the 10-year T-Note futures contract.

The seller’s risk with a covered call is limited, as the obligation to the buyer can be satisfied either by ownership of the futures position or by the cash security attached to the underlying futures contract. In cases where the seller does not have any of these items to fulfill the obligation, it is called an uncovered or naked position. It’s riskier than a covered call.

While all the terms of an option contract are predetermined or standardized, the premium paid by the buyer to the seller is determined in the market and depends in part on the chosen strike price. Options on a Treasury futures contract come in many types, and each has a different premium depending on the corresponding futures position. An option contract will specify the price at which the contract can be exercised as well as the month of expiration. The predefined price level selected for an option contract is called strike price or exercise price.

The difference between an option’s strike price and the price at which its corresponding futures contract trades is called intrinsic value. A call option will have intrinsic value when the strike price is lower than the current forward price. On the other hand, a put option gains intrinsic value when its strike price is higher than the current price of the futures contract.

An option is “at the money” when the strike price is equal to the price of the underlying contract. An option is in-the-money when the strike price indicates a profitable trade (below the market price for a call option and above the market price for a put option). If exercising an option results in an immediate loss, the option is called out of the money.

An option’s premium also depends on its time value, that is, the possibility of a gain in intrinsic value before expiration. Generally, the higher the time value of an option, the higher the option premium will be. Time value decreases and decreases as an option contract expires.

Cash bond options

The market for options on cash bonds is smaller and less liquid than that for options on Treasury futures. Cash bond options traders don’t have many practical ways to hedge their positions, and when they do, it costs them more. This has turned many people away from trading over-the-counter (OTC) cash bond options, as these platforms cater to the specific needs of clients, especially institutional clients like banks or hedge funds. Specifications such as strike price, expiration dates and face value can be customized.

The essential

Debt options offer investors an efficient way to manage their interest rate exposure and take advantage of price volatility. Among debt market derivatives, the greatest liquidity is in US Treasury futures and options. These products enjoy wide market participation around the world through exchanges such as CME Globex.

Comments are closed.