A quick guide to debt options

Many government expenditures exceed taxes. As an alternative to raising taxes, these governments raise funds by selling government bonds (such as U.S. Treasuries). Government bonds are considered risk-free because stable governments are not expected to default. When stocks look weak, these debt instruments are more popular, encouraging disturbed investors to seek safer options.

Another way to invest in debt instruments and government bonds is through derivatives including futures and options. One factor that poses a risk to debt instruments is interest rates. Generally speaking, bond prices will fall as interest rates rise, and vice versa. Options linked to interest rate instruments such as bonds are a convenient way to hedge interest rate fluctuations. In this category, Treasury futures options are very popular because of their liquidity and transparency. Cash bonds also have options.

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Key points

  • Debt options are derivative contracts that use bonds or other fixed-income securities as their underlying assets.
  • A call option gives the holder the right to purchase a bond at a preset price on or before the expiry date, but has no obligation, while a put option gives a sell option.
  • The most common debt options actually use bond futures as their underlying and are settled in cash.
  • Debt options are closely related to interest rate options because bond prices are inversely proportional to changes in interest rates.

Bond futures options

Option contracts provide flexibility because the buyer is buying the right (not the obligation) to buy or sell the underlying instrument at a predetermined price and expiry date. The option buyer pays a premium for this right. The premium is the biggest loss the buyer will bear, and the profit is theoretically unlimited. The opposite is true for the option author (the person who sells the option). For option sellers, the maximum profit is limited to the premium received, while the loss is unlimited.

The option buyer can buy (call options) or sell (put options) the right of the underlying futures contract. For example, the buyer of a 10-year U.S. Treasury call option holds a long position, while the seller holds a short position. In the case of a put option, the buyer holds a short position in the futures contract, while the seller holds a long position in the futures contract.

Overview of debt options
call Put option
Buy The right to purchase futures contracts at a specified price The right to sell futures contracts at a specified price
strategy Bullish: Expect price increase/decrease in interest rates Bearish: Expectation of falling prices/rising interest rates
Sell Obligation to sell futures contracts at a specified price Obligation to purchase futures contracts at a specified price
strategy Bearish: Expect price increase/decrease in interest rates Bearish: Expectation of falling prices/rising interest rates

Covered options

If the option seller holds an offsetting position in the underlying commodity or futures contract, the option is said to be an “override” option. For example, if the seller holds a spot market T-Notes or is long a 10-year T-Note futures contract, the seller of the 10-year Treasury futures contract will be referred to as coverage.

The seller’s risk in a guaranteed call option is limited because the obligation to the buyer can be fulfilled through ownership of the futures position or cash securities related to the underlying futures contract. If the seller does not own any of these to fulfill its obligations, it is called an uncovered or bare location. This is more risky than a guaranteed phone call.

Although all the terms of an option contract are predetermined or standardized, the premium paid by the buyer to the seller is determined by the market and partly depends on the selected strike price. There are many types of options for treasury bond futures contracts, and each has a different premium according to the corresponding futures position. The option contract will specify the price at which the contract can be exercised with the expiration month. The predefined price level selected for an option contract is called its strike price or strike price.

The difference between the exercise price of an option and the transaction price of its corresponding futures contract is called the intrinsic value. When the strike price is lower than the current futures price, the call option will have intrinsic value. On the other hand, when the strike price is higher than the current futures price, the put option will gain intrinsic value.

When the strike price is equal to the price of the underlying contract, the option is “at par”. When the strike price indicates that the transaction is profitable (the call option is lower than the market price, and the put option is higher than the market price), the option is an in-the-money option. If the exercise of the option means an immediate loss, the option is called back.

The premium of an option also depends on its time value, that is, the possibility of any gain from its intrinsic value before expiration. Generally speaking, the greater the time value of an option, the higher the premium. The time value decreases and decays as the option contract approaches expiration.

Cash bond options

Compared with treasury bond futures options, the cash bond options market is smaller and less liquid. Traders of cash bond options do not have many convenient ways to hedge their positions, and when they do, the cost will be higher. This makes many people turn to over-the-counter cash bond options (OTC) because such platforms cater to the specific needs of customers, especially institutional customers such as banks or hedge funds. Specifications such as execution price, expiration date and face value can be customized.

Bottom line

Debt instrument options provide an effective way for investors to manage interest rate risk and benefit from price fluctuations. Among the derivatives in the debt market, the most liquid is US Treasury futures and options. These products have gained extensive market participation from all over the world through exchanges such as CME Globex.

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