In finance, an OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price is referred to as bond option. It is identical to a stock option having only one difference and that is the underlying asset is a bond. Black model is used to value bond options.

The bond’s present market value is known as the spot price while the bond’s future value as per the option is known as the strike price.

Types

• An option to buy or sell a bond at a certain date in future for a predetermined price is known as European bond option.

• An option to buy or sell a bond on or before a certain date in future for a predetermined price is known as American Bond option.

Embedded Option

For option-like features of some bonds the term "bond option" is also used. Rather than a separately traded product these are an inherent part of the bond. A bond may have lots of options embedded as these options are not mutually exclusive.

• By a callable bond then he is allowed to buy back the bond at a predetermined price at certain time in future. In effect, the holder of such a bond has sold a call option to the issuer. For the first few years of their life callable bonds cannot be called. This period in which they cannot be called upon is known as the lock out period.

• By a puttable bond then he is allowed to demand early redemption at a predetermined price at certain time in future. In effect, the holder of such a bond has  purchased a put option on the bond.

• By a convertible bond the holder is allowed to demand conversion of bonds into the stock of the issuer at a predetermined price at certain time period in future.

• By an exchangeable bond the holder is allowed to demand conversion of bonds into the stock of a different company, usually a public subsidiary of the issuer, at a predetermined price at certain time period in future.

Relationship with Caps and Floors

European Put options on zero coupon bonds can be considered to be equivalent to suitable caplets, i.e. interest rate cap components, whereas call options can be considered to be equivalent to suitable floorlets, i.e. components of interest rate floors.

Uses

The major advantage that is offered by a bond option is the Locking-in price of the underlying bond for future thereby it reduce the credit risk that is associated with the fluctuations in the bond price.

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