In financea 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.

Bondsthe 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 processand cannot therefore be applied here; [1] 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-ToyHo-Lee or Hull—White. For American- and Bermudan- styled optionswhere 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 Mercuriowho also discuss bond options valuation with different models. From Wikipedia, the free encyclopedia.

Bank A Underlying asset: FNMA Bond Spot Price: 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 courses on stock trading canada dummies exercise the option.

In either case, Bank A has lost the premium to Bank Binary options brokers with a small deposit. 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.

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By using this site, you agree to the Terms of Use and Privacy Policy. Privacy policy About Wikipedia Disclaimers Contact Wikipedia Developers Cookie statement Mobile view. On the Trade Date, Bank A enters into an option with Bank B to buy certain FNMA Bonds from Bank B for the Strike Price mentioned.

Terms Credit spread Debit spread Exercise Expiration Moneyness Open interest Pin risk Risk-free interest rate Strike price the Greeks Volatility.