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In finance , a bond option is an option to buy or sell a bond at a certain price on or before the option expiry date. Generally, one buys a call option on the bond if one believes that interest rates will fall, causing an increase in bond prices.
Likewise, one buys the put option if one believes that the opposite will be the case. Bonds , the underlyers in this case, exhibit what is known as pull-to-par: On the other hand, the Black—Scholes model, which assumes constant volatility, does not reflect this process , and cannot therefore be applied here;  see Black—Scholes model Valuing bond options.
Addressing this, bond options are usually valued using the Black model or with a lattice-based short rate model such as Black-Derman-Toy , Ho-Lee or Hull—White. For American- and Bermudan- styled options , where exercise is permitted prior to maturity, only the lattice-based approach is applicable. The term "bond option" is also used for option-like features of some bonds " embedded options ". These are an inherent part of the bond, rather than a separately traded product.
These options are not mutually exclusive, so a bond may have several options embedded. Here, the bond is priced as a "straight bond" i. The option value is then added to the straight bond price if the optionality rests with the buyer of the bond; it is subtracted if the seller of the bond i.
European Put options on zero coupon bonds can be seen to be equivalent to suitable caplets, i. See for example Brigo and Mercurio , who also discuss bond options valuation with different models. From Wikipedia, the free encyclopedia. Bank A Underlying asset: Bank A pays a premium to Bank B which is the premium percentage multiplied by the face value of the bonds.
At the maturity of the option, Bank A either exercises the option and buys the bonds from Bank B at the predetermined strike price, or chooses not to exercise the option. In either case, Bank A has lost the premium to Bank B. A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price. An American bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price.
Bond Debenture Fixed income. Accrual bond Auction rate security Callable bond Commercial paper Contingent convertible bond Convertible bond Exchangeable bond Extendible bond Fixed rate bond Floating rate note High-yield debt Inflation-indexed bond Inverse floating rate note Perpetual bond Puttable bond Reverse convertible securities Zero-coupon bond.
Asset-backed security Collateralized debt obligation Collateralized mortgage obligation Commercial mortgage-backed security Mortgage-backed security. Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative. Retrieved from " https: Bonds finance Options finance.