Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Yield-Based Option

What it is:

A yield-based option is a financial instrument that gives the owner the right but not the obligation to purchase a debt security. The value of the yield-based option depends on the difference between the strike price, expressed as a percentage, and the yield on the debt security.

How it works (Example):

Every option represents a contract between a buyer and seller. The seller (writer) has the obligation to either buy or sell the debt security (depending on what type of option he or she sold -- either a yield-based call option or a yield-based put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer has the right, but not the obligation to complete the transaction on a specified date (yield-based options are European options, meaning that they can only be exercised on the expiration date rather than before). When an option expires, if it is not in the buyer's best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future -- hence the name.

As a quick example of how yield-based call options make money, let's say the debt security has a yield of 7.5%. Now let's say an investor purchases one yield-based call at a price of $100 per contract.

Here's what will happen to the value of this call option under different scenarios:

When the option expires, the yield on the debt is 7.7%
Remember: The yield-based call option gives the buyer the right to purchase the debt on or before January 1. The buyer could use the option to purchase that debt at a 7.5% yield, then immediately sell the debt the open market at its 7.7% yield. This option is therefore called "in the money." Because of this, the option will sell for $200. Because the investor purchased this option for $100, the net profit to the buyer from this trade will be $100.

When the option expires, the yield on the debt is at or below 7.5%
If the yield on the debt ends up at or below 7.5% on the option's expiration date, then the contract will expire "out of the money." It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the $100 that he or she spent for the option).

Why it Matters:

As with stock options, with yield-based options one party is expecting the value of the underlying security to go in one direction, and the other party is expecting the value of the underlying security to go in the other direction. In particular, a buyer of yield-based options expects interest rates to go up (and thus bond prices to go down, which makes bond yields go up).

Investors use options for two primary reasons -- to speculate and to hedge risk. To speculate is to simply bet on the direction of interest rate changes. Hedging, however, is like buying insurance -- it is protection against unforeseen events. Using options to hedge a portfolio accomplishes this for some investors.