A bond option is a financial derivative that allows the holder to buy or sell a bond at a specified price. There are two types of options, call and put, and they can be American or European. The price is determined using the Black-Scholes method.
A bond option is a financial derivative. It gives the holder the ability to buy or sell a quantity of a bond at a specified price. A bond option is like any other option, except that the underlying asset is a bond. Other options are derived from stocks or exchange rates. Options are valued based on the expected benefit that the holder will receive up to the expiration date of the option.
A bond is a note issued by an entity and sold to raise funds. The issuing entity guarantees the holder the payment of a specific amount on the maturity date of the bond. Bonds differ from stocks in that the buyer of a bond buys a debt instrument, and the company promises to pay that debt. In contrast, shares are equity instruments; The holder of a share owns a portion of the profits of a corporation. Shares have no expiration date, and only some shares pay cash dividends, while others must be sold for the investor to make a profit.
There are two types of options. A call is an option to sell, and a put is an option to buy. A bond option contract specifies the amount of the bond that can be bought or sold. It also designates the cost at which the transaction will take place: the strike price. The holder is not required to exercise the option; If it is not profitable to buy or sell at the strike price, you can let the option expire and you lose the purchase price of the option.
Both put and call can be divided into two classes: American and European. A US option can be exercised at any time on or before the expiration date, and a European option can only be exercised on its expiration date. US options offer greater flexibility and therefore provide more opportunities for profit. A US option is profitable if the price of the underlying bond is favorable on any date before the option expires, while a European option is profitable only if the price is favorable on a specific date. Therefore, the American options cost more.
The price of a bond option is determined using the Black-Scholes method, just like other option prices. Analysts determine the expected value of the gains that can be realized in various future states. Those are weighted by the probability of each state, and the resulting figure is the theoretical price of the option.
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