- Last Updated: Monday, 29 March 2021
Many investors are familiar with stock options, but trading in bond options is possible too. In fact, the way these contracts are traded is very similar to stocks; investors familiar with one process shouldn’t have any trouble adapting to the other.
In this article, we’re going to review the topic of bond options. As part of that review, we’ll first discuss the basics of trading options, including why investors might want to participate in this market. Next, we’ll run through the features commonly found in these investments. Then we’ll finish up with a high level review of the options pricing models in use, including the important variables, or factors, utilized in their calculations.
Buying Bond Options
A good working definition of a bond option can be stated something like the following:
A bond option is a contract giving the investor, or issuing company, the right to either acquire or sell a bond at a future point in time at a pre-established price.
Notice the above definition states a bond option can either give the investor or issuing company the right to buy or sell a bond. A put option is used when an investor wants the right to sell a bond at a future point in time. A call option is used when the issuer wants the right to purchase a bond at a future point in time.
Also known as put bonds, or putable bonds, a put option allows the investor to force the company issuing the bond to pay back the principal at any point in time before the bond matures. If an investor is worried about interest rates increasing after they purchase a bond, they might consider investing in a put option. The investor then has the right to force the issuing company to repurchase the bond by paying back the principal owed. This allows the investor to move their money from a lower interest paying security to one offering greater returns. Investors might also want to purchase a put option if they believed the financial position of the company could deteriorate over time, and they want the ability to force the issuing company to repurchase their bond.
Also known as callable bonds, or redeemable bonds, a call option allows the issuer to redeem the bond before it matures. Under most circumstances, the call price will be greater than the par value of the bond. Since the bondholder assumes the risk the security will be redeemed before it matures, the issuer will pay a premium in the form of a higher coupon rate (interest rate).
Companies are willing to pay this premium because it gives them the right to refinance debt if interest rates decline. Unfortunately for the bondholder, when a security is redeemed, they may need to find an alternate investment at an inopportune time.
Callable Bond Types
Generally, there are three different types of callable bonds:
- American Bond Option: provides for the ability to buy or sell a bond on, or before, a future date at a predetermined price.
- European Bond Option: provides for the ability to buy or sell a bond on a future date at a predetermined price.
- Bermudan Bond Option: provides for the ability to buy or sell a bond on specified future dates, typically the coupon payment dates, at a predetermined price.
In addition to call options, there may be other embedded features the issuer might include when marketing the bond. Such embedded features can include:
- Exchangeability: allows the issuer to exchange the bond for shares of stock in another corporation at a predetermined price, and within a given time period.
- Convertibility: allows the issuer to convert the bond into shares of the issuing company’s stock at a predetermined price, and within a given time period.
Valuing Bond Options
As is the case when calculating yield to maturity, as a bond approaches its maturity date, its value becomes less volatile. This happens because an increase, or decrease, in interest rates has less effect on the price of a bond as the time to maturity decreases. This stabilization of price is referred to as pull-to par. The mathematical models typically used to value bond options include:
- Black-Derman-Toy Model: also known as the BDT, this model is used in the pricing of bond options, swaptions, as well as interest rate derivatives.
- Hull-White Model: a mathematical way to describe the change in interest rates such that Bermudan swaptions and bond options can be valued.
- Black Model: also known as the Black-76 Model, this model is used in the pricing of bond options, swaptions, as well as interest rate caps and floors.
Factors Used in Valuations
The average investor does not have to be familiar with the mathematical formulas used in the above mentioned models. However, knowledge of the variables used will help investors think through the potential risks associated with these investments.
The factors commonly used in these models, as they relate to bond options, include:
- Spot Price: the current price at which a bond can be purchased or sold.
- Forward Price: the predetermined delivery price at which a bond can be purchased or sold in the future.
- Volatility: the estimated change in the value of the bond, this is a forward-looking measure and, as such, it is an implied volatility.
- Time to Expiration: the date on which the option expires, if an option is not exercised before its expiration date, then it is worthless to the investor.
- Interest Rate: the final consideration programmed into a model is interest rates. Oftentimes, the interest rate curve is used when pricing these investments.
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