Yield-based options are based on changes in bond yields in the U.S. Treasury debt market. For example:
Long 1 Jul TYX 35 call @ $4
TYX is the 30-year Treasury bond yield index (and it’s typically the only yield index tested on the exam). If you’re long TYX, you’re expecting yields to rise. In this example, the call becomes in the money (gains intrinsic value) when the 30-year Treasury yield rises above 3.5%.
You’ll notice a pattern across non-equity options: they work a lot like standard equity options, with a few key differences. Yield-based options follow that same idea.
The main difference is the strike price format. To find the actual strike (the yield level), place a decimal between the first and second digits. That’s why a TYX 35 strike corresponds to a 3.5% yield. Aside from this strike convention, yield-based options behave like standard equity options.
An investor goes long 1 Jul TYX 35 call at $4. Answer the following questions:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at a yield of 4.0%
- Gain or loss at a yield of 3.0%
A long call has unlimited profit potential. The further the 30-year Treasury yield rises above 3.5%, the more intrinsic value the call gains, and the more the investor profits.
If the 30-year Treasury yield stays at or below 3.5%, the call expires worthless. The most a long option holder can lose is the premium paid. A $4 premium equals $400 total ($4 × 100).
Breakeven occurs when intrinsic value equals the premium paid.
At 39 (3.9%), the option is in the money by 4. Exercising produces $400 (4 × 100), which exactly offsets the $400 premium.
At 40 (4.0%), the option is in the money by 5. Exercising produces $500 (5 × 100). Subtract the $400 premium, and the net result is a $100 gain.
At 30 (3.0%), the call is out of the money and expires worthless. The investor loses the $400 premium.
Yield-based options are commonly used by investors with large positions in debt securities (especially long-term bonds). Fixed income securities lose value when interest rates (and yields) rise, which is known as interest rate risk. Longer-term bonds - especially those with 20-30+ years to maturity - are typically more exposed to this risk.
Let’s apply that idea:
An investor with an extensive bond portfolio is concerned about interest rate risk and wants to utilize yield-based options to hedge herself. Which of the following options should you recommend?
A) Long TYX calls
B) Short TYX calls
C) Long TYX puts
D) Short TYX puts
Answer: A) Long TYX calls
Start by eliminating the short options. For hedging, long options are usually preferred because they provide asymmetric protection: the most you can lose is the premium, while the payoff can expand as the risk event becomes more severe.
This investor is worried about interest rate risk:
So she wants a position that tends to profit when yields rise. Since yields and interest rates move in the same direction, the appropriate hedge is a bullish yield position: long TYX calls.
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