Many governments spend in excess of tax revenue. As a substitute for mountain climbing taxes, these governments raise funds by selling government bonds, resembling U.S. Treasury bonds. Government bonds are considered risk-free because stable governments are usually not expected to default. These debt instruments are more popular when stocks look weak, encouraging skittish investors to hunt safer options.
One other option to spend money on debt instruments and government bonds is via derivatives that include futures and options. One factor posing a risk to debt instruments are rates of interest. As a general rule, bond prices fall as rates of interest rise, and vice versa. Options tied to interest-rate instruments resembling bonds are a convenient option to hedge against fluctuating rates. Inside this category, options on Treasury futures are popular because they’re liquid and transparent. There are also options on money bonds.
Key Takeaways
- Debt options are derivatives contracts that use bonds or other fixed-income securities as their underlying asset.
- Calls give the holder the fitting, but not the duty, to purchase bonds at a pre-set price on or before their expiration date, while puts give the choice to sell.
- Essentially the most common debt options actually use bond futures as their underlying and are money settled.
- Debt options work hand-in-hand with rate of interest options since bond prices vary inversely with changes in rates of interest.
Options on Bond Futures
Options contracts provide flexibility because the purchaser is buying the fitting (somewhat than an obligation) to purchase or sell the underlying instrument at a predetermined price and expiry date. The choice buyer pays a premium for this right. The premium is the utmost loss the client will bear, while the profit is theoretically unlimited. The alternative is true for the choice author (the one that sells the choice). For the choice seller, the utmost profit is proscribed to the premium received, while losses may be unlimited.
The choices buyer should buy the fitting to purchase (call option) or to sell (put option) the underlying futures contract. For instance, a buyer of a call option for a 10-year Treasury Note is taking an extended position, while the vendor is taking a brief position. Within the case of a put option, the client is taking a brief position, while the vendor is taking an extended position within the futures contract.
| Debt Options Overview | ||
|---|---|---|
| Calls | Puts | |
| Buy | The appropriate to purchase a futures contract at a specified price | The appropriate to sell a futures contract at a specified price |
| Strategy | Bullish: Anticipating rising prices/falling rates | Bearish: Anticipating falling prices/rising rates |
| Sell | Obligation to sell a futures contract at a specified price | Obligation to purchase a futures contract at a specified price |
| Strategy | Bearish: Anticipating rising prices/falling rates | Bearish: Anticipating falling prices/rising rates |
Covered Options
An option is claimed to be “covered” if the choice author holds an offsetting position within the underlying commodity or futures contract. For instance, a author of a 10-year Treasury futures contract could be called covered if the vendor either owns money market T-Notes or is long the 10-year T-Note futures contract.
The vendor’s risk with a covered call is proscribed, as the duty towards the client may be met either by the ownership of the futures position or the money security tied to the underlying futures contract. In cases where the vendor doesn’t possess any of those to satisfy the duty, it is known as an uncovered or naked position. That is riskier than a covered call.
While all terms of an option contract are predetermined or standardized, the premium paid by the client to the vendor is set within the marketplace and partially is determined by the chosen strike price. Options on a Treasury futures contract can be found in many sorts, and every has a unique premium based on the corresponding futures position. An option contract will specify the worth at which the contract may be exercised together with the expiration month. The predefined price level chosen for an option contract is known as its strike price or exercise price.
The difference between the strike price of an option and the worth at which its corresponding futures contract is trading is known as the intrinsic value. A call option may have an intrinsic value when the strike price is lower than the present futures price. However, a put option gains intrinsic value when its strike price is bigger than the present futures price.
An option is “at the cash” when the strike price is the same as the worth of the underlying contract. An option is in the cash when the strike price indicates a profitable trade (lower than market price for a call option, and greater than market price for put options). If exercising an option means immediate loss, the choice is known as out of the cash.
An option’s premium can also be depending on its time value, that’s, the opportunity of any gain in intrinsic value before expiry. As a general rule, the greater the time value of an option, the upper the choice premium can be. Time value decreases and decays as an option contract nears expiration.
Options on Money Bonds
The marketplace for options on money bonds is smaller and fewer liquid than for options on Treasury futures. Traders in money bond options do not have many convenient ways to hedge their positions and after they do it comes at the next cost. This has diverted many towards trading money bond options over-the-counter (OTC), as such platforms cater to the particular needs of clients, especially institutional clients like banks or hedge funds. Specifications resembling strike price, expiration dates, and face value may be customized.
The Bottom Line
Options on debt instruments provide an efficient way for investors to administer rate of interest exposure and profit from price volatility. Amongst debt market derivatives, essentially the most liquidity can be found with U.S. Treasury futures and options. These products have wide market participation from all over the world through exchanges resembling CME Globex.