Options

Options are mainly categorized in two forms. 1. Call options and 2. Put options. A call option gives the owner of the option the right to purchase a security at a pre-specified strike price for a specific period of time. A put option gives the holder of the option the right to sell the option at a pre specified strike price and period of time. Options are available for interest rate futures (which are traded on the CBOT) as well as regular fixed income products like bonds.

A very important factor to consider when dealing with fixed income options is option adjusted spread. Very often the price or yield of a corporate bond is expressed as a spread to a risk free government bond with the same maturity. However when a bond has an option embedded in it the yield will change. This is because the price of a bond with an option embedded in it is the price of the bond + the option value. This means that when calculating the yield (as was done in equation 1) the price needs to take the option value into a count. A very sophisticated and popular technique is called option adjusted spread. This simply creates a binomial tree and as a result strips off the option component to calculate the resulting option free yield. The option adjusted spread is the spread to the risk free government bond with the same maturity once the option component has been taken out. A popular fixed income product that has options embedded into it are convertible bonds. Generally these are structured as a bond which have the option to convert the bond into the common stock of the company which has issued the bonds. Option adjusted spread is crucial in analyzing convertible bonds.