Yield-based options are based on changes in bond yields in the Treasury (U.S. Government) 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. An investor who is long TYX is expecting bond yields to rise. In this example, the call goes in the money (gains intrinsic value) when the 30-year Treasury yield rises above 3.5%.
You’ve probably noticed a theme throughout the non-equity option chapter: non-equity options work a lot like standard equity options, with a few unique features. Yield-based options follow the same pattern.
The main unique feature is the strike price. To find the actual strike (the yield level), place a decimal between the first and second digits. That’s why a TYX 35 call is a bet that 30-year Treasury yields will rise above 3.5%. Aside from how the strike is quoted, 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 gain potential. The higher the 30-year Treasury yield rises above 3.5%, the more intrinsic value the call gains, and the more the investor profits.
If 30-year Treasury yields stay at or below 3.5%, the call remains out of the money and expires worthless. For an option buyer, the worst-case outcome is losing 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 call is in the money by 4. If exercised, the writer must deliver $400 (4 × 100), which exactly offsets the $400 premium paid.
At 40 (4.0%), the call is in the money by 5. If exercised, the writer must deliver $500 (5 × 100). Subtract the $400 premium paid:
$500 − $400 = $100 gain
Gain or loss at 30 (3.0%) = $400 loss
At 30 (3.0%), the call is out of the money and expires worthless. The investor loses the premium paid: $400.
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. This exposure is called interest rate risk. Longer-term bonds - especially those with 20-30+ years to maturity - are typically more sensitive to rising rates.
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 can provide meaningful protection if the risk event occurs. A short option position has limited profit potential (the premium received), which may not offset large losses in the underlying portfolio.
This investor is worried about rising interest rates. When rates rise, bond prices fall, and her bond portfolio would lose value.
To hedge, she wants an option position that profits when yields rise. Interest rates and yields move in the same direction. So if rates rise, yields rise as bond prices fall. A long TYX call benefits from rising yields, making it the appropriate hedge.
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