Options on bonds, usually called bond options, are primarily traded in the over-the-counter markets. Options exchanges have attempted to generate interest in options on bonds, but have not been very successful. Corporate bonds are not very actively traded; most are purchased and held to expiration. Government bonds, however, are very actively traded; nevertheless, options on them have not gained widespread acceptance on options exchanges. Options exchanges generate much of their trading volume from individual investors, who have far more interest in and understanding of stocks than bonds. Thus, bond options are found almost exclusively in the over-the-counter market and are almost always options on government bonds. Consider, for example, a U.S. Treasury bond maturing in 27 years. The bond has a coupon of 5.50 percent, a yield of 5.75 percent, and is selling for $0.9659 per $1 par. An over-the-counter options dealer might sell a put or call option on the bond with an exercise price of $0.98 per $1.00 par. The option could be European or American. Its expiration day must be significantly before the maturity date of the bond. Otherwise, as the bond approaches maturity, its price will move toward par, thereby removing much of the uncertainty in its price. The option could be specified to settle with actual delivery of the bond or with a cash settlement. The parties would also specify that the contract covered a given notional principal, expressed in terms of a face value of the underlying bond.
Continuing our example, let us assume that the contract covers $5 million face value of bonds and is cash settled. Suppose the buyer exercises a call option when the bond priceis at $0.995. Then the option is in-the-money by $0.995 – $0.98 = $0.015 per $1 par. The seller pays the buyer 0.015($5,000,000) = $75,000. If instead the contract called for delivery, the seller would deliver $5 million face value of bonds, which would be worth $5,000,000($0.995) = $4,975,000. The buyer would pay $5,000,000($0.98) = $4,900,000. Because the option is created in the over-the-counter market, the option buyer would assume the risk of the seller defaulting.
Even though bond options are not very widely traded, another type of related option is widely used, especially by corporations. This family of options is called interest rate options. These are quite different from the options we have previously discussed, because the underlying is not a particular financial instrument