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Options on specific bonds

An option on a specific bond, also called a bond option, may be defined as an option to buy (call) or sell (put) a specific bond on or before an expiry date at a pre-specified price or rate. "Price or rate" is mentioned because some markets deal on price and some on rate. Bond option markets are OTC or exchange-driven markets.

In the OTC options markets, the contracts are generally standardised (in most respects). Options are written on the most marketable short- and long-term bonds, which are the high-capitalisation bonds.

The OTC bond options written and traded are of the standardised and American variety. European options are also written from time to time, and there are also non-standardised options. The latter, which include "overnighters" (i.e. contracts written to expire the following day) are usually written to suit particular hedging strategies. They differ from the standardised contracts in terms of expiration date and strike rate level.

The main characteristics of standardised bond options are shown in Table 9.

Size of contract

LCC 1 million (nominal value), but the standard trading amount is LCC 10 million or multiples of this amount

Underlying instruments

Various government and public enterprise bonds

Market price/rate

Yield to maturity

Strike rate intervals

0.25%, for example 8.00%, 8.25%, 8.50%, 8.75%

Expiry dates

12 noon on the first Thursday of February, May, August and November

Commission

As there are no fixed commission rates, the commission is included in the premium paid by the purchaser

Form of settlement

Cheque for the premium negotiated on the day of settlement

Table 9: Characteristics of standardised bond options

Listed bond options are options on specific bonds that are listed on an exchange. Many exchanges have such options.

Options on bond indices

A bond index option may be defined as an option to buy (call) or sell (put) a specific bond index on or before an expiry date at a pre-specified price (not rate; rate applies to options on specific bonds). Local Country, for example, has the following bond indices56:

All Bond Index (ALBI), consisting of the most liquid sovereign (i.e. central government) and non-sovereign (e.g. local government, public utilities and corporate) bonds.

Government Bond Index (GOVI), containing those government bonds of the ALBI in which the primary dealers make a market, i.e. the most liquid bonds.

Other Bond Index (OTHI), being the non-government bonds in the ALBI basket.

The indices enable investors to measure the performance of bonds of various terms. Bond options are written on these three indices.

Bond warrants (call options)

There are two types of bond warrants:

• Bond warrants (retail options).

• Bond warrants (call options).

The term "bond warrant" internationally generally refers to call options on specific bonds but with a difference: when a bond warrant (call option) is exercised, this leads to the issuer issuing new bonds. In the case of the ordinary bond options, the issuer is not involved - the writer of a call that is exercised sells existing bonds to the holder of the option.

The term to expiry of bond warrants (call options), unlike normal options, is long, sometimes running for many tears. The underlying bond also has a long term to maturity, usually 10 years or longer.

Bond warrants (retail options)

In some countries, however, the term "bond warrant" refers to ordinary options on specific bonds, but they are retail options, i.e. the denominations are small. Calls and puts are written and traded and a call does not lead to the issue of new bonds.

The issuer of bond warrants is an entity, usually a bank, which is not associated with the issuer of the underlying bond (which in the main is government bonds). The issuer of the warrant is the writer, and the holder therefore has the right to exercise it against the issuer. As such the warrant holder assumes counterparty risk, i.e. the credit risk associated with the issuer.

Bond warrants enable investors / speculators to profit from expected movements in interest rates on specific bonds. Call warrants are bought in order to profit from an expected increase in the bond price (decrease in ytm), and bond put warrants are bought to profit from an expected decrease in the bond price (increase in the ytm).

There are two types of bond warrants: American or European. They are usually listed on the exchange and are traded and settled with members of the exchange (therefore settlement is guaranteed by the exchange). The issuers of warrants make a market in them by quoting bid and offer prices simultaneously at all times. The buyer pays the premium quoted by the market-maker. Bond warrants are cash settled.

The advantages of warrants and the risks associated with warrants are covered under equity warrants below, as this is the largest warrants market in most countries.

Callable and puttable bonds (bonds with embedded options)

Bonds with embedded options are bonds that are issued with provisions that allow the issuer to repurchase (callable bond) the bond, or the holder to sell back to the issuer (puttable bond) the bond at a pre-specified price/rate at certain dates in the future.

The callable bond means that the buyer of the bond has sold to the issuer a call option to repurchase the bond. The strike price/rate (also called the call price) is the pre-determined price/rate that the issuer is obliged to pay to the bondholder.

It is usual that callable bonds are not callable for some years after issue. For example, a 15-year bond may not be callable for 10 years, and a price is set for each year after 10 years. A portion of the bond or the full amount may be callable. The fact that the buyer has "sold" to the issuer a call option means that these bonds are issued at a lower price (higher rate) than equivalent term and rated "ordinary" bonds.

Puttable bonds, i.e. bonds with embedded put options, are also issued in some markets. As noted, such bonds have provisions that allow the holder to sell the bond back to the issuer at pre-specified prices/ rates on pre-determined dates. This means that the holder of the bond has bought a put option from the issuer. These bonds are issued and trade at lower yields (higher price) than equivalent term and rated bonds without such options attached.

Convertible bonds

Convertible bonds are bonds that are convertible into shares (ordinary or preference) at the option of the holder on pre-specified terms (e.g. number of shares per nominal value).

 
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