What it means
An option gives the buyer the right, but not the obligation, to receive a payment depending on how a reference value ends up. In an ordinary bond option the reference is a bond's price, while in a yield-based option it is the yield itself.
The option is usually settled in cash, so no bond changes hands. A call on yield gains when the yield rises above the strike, and a put on yield gains when the yield falls below it.
This is the reverse of the relationship in bond prices, since a rising yield means a falling price. Reading the direction correctly is the most important step in using one.
Companies use yield-based options to hedge interest rate exposure. A borrower with a floating-rate loan who fears higher rates could buy a call on yield, so that the payoff offsets the extra interest.
If rates fall instead, the borrower loses only the premium, which is the price paid for the option. Investors and traders also use them to take views on rates.
They provide a direct way to speculate on a yield level with a known maximum loss, which is the premium. Because the option settles on a yield, the payoff is easy to relate to rate moves.
Contract terms vary, including the reference yield, the way the payoff is scaled and the expiry date. Exchange-traded versions have standard terms, while over-the-counter versions can be tailored.
A user should read the contract specification to understand exactly how the payoff is calculated. Accounting and governance deserve attention as well.
A company that buys an option to hedge a loan needs documentation showing the link between the option and the exposure, otherwise changes in the option's value may flow through profit in an unexpected way. The treasury policy should state who may trade options, with what limits and for what purpose.
In practice
Real-world examples.
Example
A property developer has a floating-rate loan and worries that rates will rise before the project is sold. The treasurer buys yield-based call options. When yields rise, the payoff offsets part of the higher interest cost.
Example
A fund manager believes that long-term yields will fall because of weakening growth. She buys put options on yield, which gain if yields fall below the strike. The cost of the premium is the most she can lose.
Example
A bank with a portfolio of fixed-rate loans buys options on yields to protect against a rise in funding costs. The options pay out in a rising rate environment, helping to protect the bank's margin. The treasury team documents the hedge for accounting purposes and reports its value to the risk committee each quarter. The committee checks that the option still matches the size and timing of the exposure.
Formula
Calculation
Call payoff = (yield at expiry - strike yield) x contract value per percentage point, if positive
Net profit = payoff - premium paid
Suppose a company buys a call option on a 10-year government yield with a strike of 4.00%, paying a premium of $350 per contract. Each percentage point of yield is worth $1,000 per contract. At expiry the yield is 4.60%, so payoff = (4.60 - 4.00) x 1,000 = $600. Net profit = 600 - 350 = $250 per contract. If the yield had ended at or below 4.00%, the payoff would be zero and the loss would be the $350 premium.Case study
Seen in the real world.
Falcon Ridge Developments is an illustrative, fictional property group that expected to refinance a $40,000,000 loan in nine months. The finance director was concerned that a rise in long-term yields would increase the cost of the new loan.
She bought call options on a 10-year yield with a strike close to the current level, paying total premiums of $60,000. Over the following months yields rose by 0.80 percentage points, and the options paid out an amount that offset about half of the extra interest cost on the refinancing.
The remainder of the increase was absorbed in the project budget. The illustrative lesson is that an option provides protection with a limited cost, but it rarely removes the whole risk.
Watch out
Common mistakes.
- Mixing up the direction, when a call on yield gains as yields rise, which is the opposite of a call on a bond price.
- Forgetting the premium, which must be recovered before the option makes a net profit.
- Assuming the option settles by delivering a bond, when yield-based options normally settle in cash.
Questions
People also ask.
What is a yield-based option?
It is an option whose payoff depends on the level of an interest rate yield rather than on a security's price.
When does a call on yield pay off?
It pays off when the yield at expiry is above the strike yield.
Who uses these options?
Borrowers, investors and banks use them to hedge or speculate on changes in interest rates.
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