What is BOND OPTION? What does BOND OPTION mean? BOND OPTION meaning - BOND OPTION definition - BOND OPTION explanation.
Source: Wikipedia.org article, adapted under https://creativecommons.org/licenses/by-sa/3.0/ license.
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. These instruments are typically traded OTC.
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.
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. One result of trading in a bond option, is that the price of the underlying bond is "locked in" for the term of the contract, thereby reducing the credit risk associated with fluctuations in the bond price.
Bonds, the underlyers in this case, exhibit what is known as pull-to-par: as the bond reaches its maturity date, all of the prices involved with the bond become known, thereby decreasing its volatility. 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. The latter approach is theoretically more correct, , although in practice the Black Model is more widely used for reasons of simplicity and speed. For American- and Bermudan- styled options, where exercise is permitted prior to maturity, only the lattice-based approach is applicable.
Using the Black model, the spot price in the formula is not simply the market price of the underlying bond, rather it is the forward bond price. This forward price is calculated by first subtracting the present value of the coupons between the valuation date (i.e. today) and the exercise date from today's dirty price, and then forward valuing this amount to the exercise date. (These calculations are performed using today's yield curve, as opposed to the bond's YTM.) The reason that the Black Model may be applied in this way is that the numeraire is then $1 at the time of delivery (whereas under Black–Scholes, the numeraire is $1 today). This allows us to assume that (a) the bond price is a random variable at a future date, but also (b) that the risk-free rate between now and then is constant (since using the forward measure moves the discounting outside of the expectation term ). Thus the valuation takes place in a risk-neutral "forward world" where the expected future spot rate is the forward rate, and its standard deviation is the same as in the "physical world"; see Girsanov's theorem. The volatility used, is typically "read-off" an Implied volatility surface.
The lattice-based model entails a tree of short rates - a zeroeth step - consistent with today's yield curve and short rate (often caplet) volatility, and where the final time step of the tree corresponds to the date of the underlying bond's maturity. Using this tree (1) the bond is valued at each node by "stepping backwards" through the tree: at the final nodes, bond value is simply face value (or $1), plus coupon (in cents) if relevant; at each earlier node, it is the discounted expected value of the up- and down-nodes in the later time step, plus coupon payments during the current time step....