What Are Yield-Based Options?
A yield-based option allows investors to buy or sell calls and puts on the yield of a security rather than its price.
Key Takeaways
- Yield-based options allow trading on the yield of a security, not its price.
- These options offer the right, but not the obligation, to trade at an underlying value, equaling 10 times the yield.
- Ideal for hedging portfolios and gaining profits in rising interest rate environments.
- Some benefits can be accessed via options on ETFs.
Understanding Yield-Based Options
Yield-based options provide a mechanism where the underlying value is 10 times the yield of the security. For instance, a Treasury bond with a 1.6% yield would translate to a yield-based option with an underlying value of 16. These options are cash-settled and are also known as interest rate options.
Yield-based call buyers anticipate a rise in interest rates, while put buyers expect a fall. If the interest rate exceeds the strike rate of a call option, it becomes ‘in the money.’ Conversely, a put option remains ‘in the money’ if the rate drops below the strike rate. Option premiums are paid by buyers, and these premiums fluctuate based on yield changes. Call premiums rise with increasing yields, whereas put options diminish in value.
Typically, yield-based options follow the European model, meaning they can only be exercised on the expiration date, unlike American options, which can be exercised anytime before expiration. Given these are cash-settled, the option writer compensates the buyer with the difference between the actual yield and the strike yield.
Types of Yield-Based Options
Yield-based options commonly track the yields of:
- 13-week Treasury bill yields (highly responsive to rate changes).
- Five-year Treasury note yields.
- 10-year Treasury note yields.
- 30-year Treasury bond yields.
Benefits of Yield-Based Options
Yield-based options are crucial for hedging and gaining from a rising interest rate environment, providing an avenue to profit when rates increase—a rarity in conventional assets. The Federal Reserve’s rate hikes can make risk-free money market returns more appealing, leading to a drop in riskier asset prices, creating room for yield-based call options to shine, especially in periods like 1981, 1994, and even 2018.
Disadvantages of Yield-Based Options
While offering unique benefits, yield-based options might be unfamiliar compared to options on ETFs. An alternative strategy to profit from rising rates includes buying a put on a long-term Treasury ETF. Additionally, yield-based options suffer from time decay; without rate changes, their value can diminish over time.
Related Terms: Treasury bonds, Treasury notes, Treasury bill yields, American options, European options.
References
- CBOE. “Interest Rate Options”.
- Federal Reserve Bank of St. Louis. “Effective Federal Funds Rate”.
