Understanding Debt Options

12/19/2015 8:00 am EST

Focus: OPTIONS

One factor that poses a risk to debt instruments is the interest rate in the economy, so Prableen Bajpai, at Investopedia.com, illustrates how options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility.

Most governments find that their spending exceeds their revenues. As an alternative to unpopular tax hikes, governments can raise money through selling government bonds, like US Treasury bonds, for example. Government bonds are considered risk-free as most stable governments are not expected not to default on these obligations. These debt instruments are more popular in times when stock markets look weak as skittish investors seek safer options. Another way to invest in debt instruments and government bonds is through derivatives, like futures and options.

Debt Options
One factor that poses a risk to debt instruments is the interest rate in the economy. As a general rule, when the interest rate goes up, bond prices go down and vice versa. Options related to interest rate instruments like bonds are a convenient way for hedgers and speculators to deal with fluctuating interest rates. Within the category, options on treasury futures are one of the most popular as they are a liquid and transparent way to deal with exposure to interest rate and economic events. Within futures contracts, the 5-year note, 10-year note, and 30-year bond are the most traded in the world. Other than options on futures, there are options on cash bonds.

Options on Futures
Options contracts typically offer great flexibility as the offer the right (rather than the obligation) to buy or sell the underlying instrument at a predetermined price and time. Upon entering an options contract, the option buyer pays a premium. The contract will specify the expiration date of the option and various conditions. For the option buyer, the premium amount is the maximum loss that the buyer will bear while the profit is theoretically unlimited. The case for the option writer (the person who sells the option) is very different. For the option seller, the maximum profit is limited to the premium received while loss can be unlimited.

In entering an options contract, the buyer is purchasing the right to buy (called a call option) or to sell (called a put option) the underlying futures contract. For example, a call option on September 2015 10-year T-Note, gives the buyer the right to assume a long position on it while the seller is obligated to take a short position if the buyer chooses to exercise the option. In the case of a put option, the buyer has the right to a short position in the September 2015 10-year T-Note futures contract while the seller in this case must assume a long position in the futures contract.

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Table Source: CBOT
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An option is said to be covered if the option writer (seller) holds an offsetting position in the underlying commodity or the futures contract. For example, a writer of a 10-year T-Note futures contract would be called covered if the seller either owns cash market T-Notes or is long on the 10-year T-Note futures contract. The seller’s risk in selling a covered call is limited as the obligation towards the buyer can be met either by the ownership of the futures position or the cash security tied to the underlying futures contract. In cases where the seller doesn’t possess any of these to fulfill the obligation, it is called an uncovered or naked position. This is riskier than a covered call.

NEXT PAGE: Why Is the Market for Options on Cash Bonds Smaller?

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While all terms of an option contract are predetermined or standardized, the premium which is paid by the buyer to the seller is determined competitively in the market place and in part depends on the strike price chosen. Options on treasury futures contract are available in many types and each option has a different premium according to the corresponding futures position. An option contract would typically specify the price at which the contract can be exercised along with the expiration month. The predefined price level selected for an option contract is called its strike price or exercise price. Below are the specifications on an option on 10-year US Treasury Note futures on the Chicago Board of Trade (CBOT):

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The difference between the strike price of an option and the price at which its corresponding futures contract is trading is called the intrinsic value. A call option will have an intrinsic value when strike price is less than the current futures price. On the other hand, a put option has intrinsic value when strike price is greater than the current futures price.

An option is referred to as at-the-money when the strike price = price of the underlying futures contract. When the strike price is suggestive of a profitable trade (lower than market price for call option and more than market price for put option), that option is called in-the-money and is associated with a higher premium as such an option is worth exercising. If exercising an option means immediate loss, the option is called out-of-the-money.

An options premium is also dependent on its time value, that is, the possibility of any gain in intrinsic value before expiry. As a general rule, the greater the time value of an option, the higher the option premium will be. The time value decreases over time and decays as an option contract reaches expiration.

Options on Cash Bonds
The market for options on cash bonds is much smaller and less liquid than that for options on futures. Traders in cash bond options don’t have many convenient ways of hedging their positions and when they do, it comes at a higher cost. This has diverted many towards trading cash bond options over-the-counter (OTC) as such platforms cater to the specific needs of clients, especially institutional clients. All specifications like strike price, expirations, and face value can be customized.

The Bottom Line
Among debt market derivatives, US Treasury futures and options are some of the most liquid products. These products have wide market participation from around the globe through exchanges such as CME Globex. Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility.

By Prableen Bajpai, CFA (ICFAI), Contributor, Investopedia.com

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