Corporate Bond Options
Corporate bond options are over-the-counter (OTC) financial instruments. Corporate bonds represent loans made to bond holder lenders. Bonds fluctuate in price depending on interest rates, credit quality, and supply-demand factors prior to their maturity dates. Corporate bond options enable an investor to purchase or sell a certain bond at a specific time at a known price (the strike price).
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Function
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Bond options work similarly to stock options. Stocks and bonds represent two different asset classes. A bond's current market price is called the "spot" price. The future price of the bond option contract is the "strike" price.
A variety of financial models help investors to value bond options. Fisher Black, Emanuel Derman and William W. Toy developed the Black-Derman-Toy model at Goldman Sachs. Other models include Fischer Black's earlier model (the Black model), (John Hull and Alan White's) Hull-White model, and the (T.S.Y. Ho and S.B. Lee) Ho-Lee model. According to "Pricing Of Bond Options" (2008), the Ho-Lee model was groundbreaking in valuing bond options.
Features
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Over-the-counter transactions occur between buyer and seller. A broker-dealer or trader-dealer usually acts to complete the trade. For example, Insurance Company 1 wants to purchase a corporate bond call option. The insurer believes that interest rates are going to decline by a future date. Insurance Company 2 believes that interest rates will rise by a future date. Insurer 2 agrees to sell a call option to Insurer 1 in exchange for a premium payment. The payment is calculated by multiplying the premium percentage by the nominal (face) bonds' value.
The underlying security is a AAA-rated Johnson & Johnson (JNJ) bond. The transaction date is today. The maturity date is two years in the future. The current price of the bonds are 102, trading at a premium to par value of 100. The spot price of the contract is 102. The strike price of the contract is 104.
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Effects
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Insurer 1 must exercise the right to purchase the bonds from Insurer 2 at the agreed-upon strike price of 104, or decline to exercise. If interest rates have declined during the contract period, the first insurance company may decide against purchasing the bonds. Other bonds are available in the market at a cheaper price. Insurer 1 has lost the call premium in either scenario.
Misconceptions
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Bond option may also refer to embedded options, or quasi-option features of some bonds. Because these features are part of the bond and do not trade separately from the instrument, they are not like traded bond options.
A put bond allows investors to put their bonds back to the issuer before maturity at a known price and time. The investor has wisely purchased a degree of capital protection on the bonds.
Conversely, callable bonds favor the issuer. This feature allows the issuer to redeem the bonds at a known price in the future. Issuers sell callable bonds when they anticipate a decline in future interest rates.
Considerations
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Some investors use U.S. Treasury Bond options instead of over-the-counter options. With high credit corporate bonds, such as the JNJ example, the investor has more liquidity and pricing advice.
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References
Resources
- "Risk Management--Using Bond Put Options"; Griselda Deelstra, Dries Heyman, Michele Vanmaele; 2005
- "Options, Futures, and Other Derivatives"; John Hull; 2009
- Wiley Library: "Bond Options"; Marcelo Piza; 2010
- "Fixed Income Securities and Derivatives Handbook"; Moorad Choudhry; 2010
- "The Oxford Guide To Financial Modeling:"; Thomas S. Y. Ho, Sang-bin Yi; 2004
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