Bond Option
In a bond option, the underlying asset is a bond rather than a stock.
Otherwise there is no significant difference between a bond option and a
stock option. The bond option allows an investor to hedge the risk of their
bond portfolios or speculate on the direction of bond prices with limited risk.
A person who buys a bond call option is expecting a decline in interest rates
and an increase in bond prices. A person who buys a bond put option is
expecting an increase in interest rates and a decrease in bond prices.
An American bond option may be bought and sold at any time before the
expiration date. A European bond option transaction may only be exercised at
the specific date.
A convertible bond allows the holder to demand conversion of the bond into
the stock of the issuer at a predetermined price at a certain time period in
the future. An exchangeable bond allows the holder to demand conversion of
bonds into the stock of a different company, typically a public subsidiary of
the issuer, at a predetermined price at a specific time.
The major advantage of a bond option is the ability to lock in the price of
the underlying bond for the future, which reduces the credit risk associated
with the fluctuations of the bond price.
Perhaps an investor wants to invest in long-term bonds, but wants to mitigate
possible downside risk. The investor could purchase options on Treasury Bonds,
while investing the balance in short-term instruments like Treasury Bills.
This way the investor would participate in any significant bullish movements,
while their downside exposure would be limited to the cost of the calls.
Traders can purchase contracts on 30-year treasury bonds through the Chicago
Board of Trade.
Types of Financial Options
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