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A bond option is a financial derivative. It gives the holder the ability to buy or sell a quantity of a bond at a specific price. A bond option is like any other option, except that the underlying asset is a bond. Other options are derived from stocks or exchange rates. Options are valued according to the expected profit that the holder will receive through the expiration date of the option.
A bond is a note issued by an entity and sold to raise funds. The issuing entity guarantees the holder the payment of a specified amount at the bond’s maturity date. Bonds differ from stocks in that the purchaser of a bond buys a debt instrument, and the company promises to repay that debt. In contrast, stocks are equity instruments; the holder of a stock owns a portion of the profits of a corporation. Stocks have no maturity date, and only some stocks pay cash dividends, while others must be sold if the investor is to realize profit.
There are two types of options. A call is an option to sell, and a put is an option to buy. A bond option contract specifies the quantity of the bond that may be bought or sold. It also designates the cost at which the transaction will take place: the strike price. The holder is not required to exercise the option; if it is not profitable to buy or sell at the strike price, he can let the option expire, and he loses the purchase price of the option.
Both puts and calls can be further divided into two classes: American and European. An American option may be exercised at any point on or before the expiration date, and a European option may only be exercised on its expiration date. American options offer greater flexibility, and thus they provide more opportunity for profit. An American option is profitable if the price of the underlying bond is favorable at any date before the option expires, while a European option is profitable only if the price is favorable on a specific date. Thus, American options cost more.
The price of a bond option is determined using the Black-Scholes method, as are other options prices. Analysts determine the expected value of the profits that may be realized in various future states. Those are weighted by the probability of each state, and the resulting figure is the theoretical price of the option.
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