An option in which the underlying asset is a bond. Bond options involve a dual bet on both the general level of interest rates and the credit risk of the bond issuer. The payoff of a bond option is typically affected by changes in interest rates, as higher rates drive the bond price lower, and vice versa. Furthermore, the payoff may depend on the underlying bond’s price moves relative to the prices of other bonds. For example, a deterioration in the credit quality of the bond issuer will lower the underlying bond’s price, causing it to underperform against other bonds.
Bond options can be used to take a view on volatility that is independent of the direction taken by the the bond price. Also, investors who hold a specific bond can use bond options to increase the yield on their portfolios. Banks and other institutions use bond options as hedging vehicles to manage their exposures to spread risk.
This type of option is mainly traded in over-the-counter markets. It can be classified, like any ordinary option, as bond call and bond put.
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