DEBT OPTIONS
Two kinds
of debt options have been approved for trading at the date of
this booklet. One kind, called price-based options, are options
which give their holders the right either to purchase or sell
a specified underlying debt security or to receive a cash settlement
payment based on the value of an underlying debt security (depending
on whether the options are physical delivery or cash-settled options).
The other kind, called yield-based options, are options that are
cash-settled based on the difference between the exercise price
and the value of an underlying yield. The distinctions between
price-based and yield-based options are fundamental and should
be understood by readers interested in investing in debt options.
At the date
of this booklet, only yield-based options are being traded. Although
price-based options have traded in the past and may be traded
in the future, no price-based option is traded at the date of
this booklet.
The principal
risks of holders and writers of debt options are discussed in
Chapter X.
Readers interested in buying or writing debt options should not
only read this chapter but should also carefully read Chapter X, particularly the discussions under the headings "Risks
of Option Holders," "Risks ot Option Buyers," "Other
Risks," and "Special Risks of Debt Options."
RATES,
YIELDS AND PRICES OF DEBT SECURITIES
To understand
debt options, an investor should understand the relationship between
the rates or yields, which are different ways of expressing return
on debt securities, and prices of debt securities. (Coupon interest
rates of a debt security express return as a percentage of the
principal amount (par value) of the security. Yields express return
(or projected return) as a percentage of the amount invested.)
This relationship, simply stated, is that prices of debt securities
move inversely to changes in rates. Declining rates, whether on
long-term bonds or money market instruments, will generally cause
prices of outstanding debt securities to increase. Conversely,
rising rates across a particular maturity spectrum will generally
cause the prices of outstanding debt securities of that maturity
to decline.
EXAMPLE:
A 30-year Treasury bond pays interest at a 12% coupon rate.
The only time prior to maturity that investors will pay a price
of 100 (that is, 100% of par value) for the bond is when the prevailing
yield on such long-term Treasury bonds is exactly 12%. Should
rates move higher to, say, 14% for such Treasury bonds, the price
of an outstanding 12% bond would have to decline to about 86 in
order for the bond to yield 14%. If rates on such bonds subsequently
decline to 10%, the price of the 12% bond could be expected to
rise substantially above par, since it would yield 10% at a price
of 120.
Price-based
call options become more valuable as the prices of the underlying
debt securities increase, and price-based puts become more valuable
as the prices of the underlying debt securities decline. The relationship
between interest rate changes, prices, and the value of price-based
debt options can be expressed as follows:
TREASURY
SECURITIES
The underlying
debt securities of price-based options and the debt securities
from which the underlying yields of yield-based options are derived
are all Treasury securities-e.g., 30-year Treasury bonds, 10-year
Treasury notes, 5-year Treasury notes and Treasury bills.
Treasury bonds
and notes are direct obligations of the United States that pay
a fixed rate of interest semiannually. Bonds are issued for maturities
of more than ten years (although many issues are callable prior
to maturity). Notes are issued for maturities of one to ten years,
and are non-callable. New issues of bonds and notes are sold periodically
by the Treasury, usually on an auction basis. The auction price
is established by bidding and may be above or below par value.
Occasionally the Treasury will "reopen" an outstanding
issue by auctioning additional principal amounts. Government securities
dealers make secondary markets in virtually all outstanding issues,
but market activity and liquidity tend to center on the most recently
auctioned issues.
Unlike Treasury
bonds and notes, Treasury bills do not pay interest. Instead,
the Treasury sells bills at a discount from their principal amount
(par value). The investment return consists of the difference
between the discounted purchase price and the principal amount
payable at maturity. Treasury bills are issued in maturities of
13, 26 or 52 weeks.
Return on
Treasury bills is commonly expressed in terms of a discount rate
which represents an annualization (based on a 360-day year) of
the percentage discount at which the bills are sold.
EXAMPLE:
If a 13-week (91-day) Treasury bill with a principal amount
of $1 ,000,000 is sold for $970,000, the actual discount would
be $30,000 or 3% and the discount rate would be approximately
11.9% (360/91 times 3%).
Bills are
auctioned by the Treasury on a regular basis, typically at weekly
intervals for 13-week and 26-week bills and every four weeks for
52-week bills. While dealers maintain secondary markets in all
outstanding Treasury bills, activity tends to center in the most
recently auctioned issues. These are commonly referred to as the
"current" 13-week, 26-week, and "year" bills,
respectively.
YIELD-BASED
OPTIONS
All yield-based
options being traded at the date of this booklet are cash-settled
European-style options. The underlying yield of these options
is the annualized yield to maturity of the most recently issued
Treasury security of a designated maturity-e.g., 30-year, 10-year,
5-year-based upon quotations or prices determined in accordance
with a method specified by the options market on which the option
is traded. If such security is a Treasury bill, the underlying
yield is the annualized discount of the Treasury bill. (A discount
represents a percentage of principal amount, rather than a return
on investment, and is therefore not a true yield.) Underlying
yield is stated in terms of a yield indicator, which is the percentage
yield multiplied by ten. For example, if the yield is based on
a Treasury bill having an annualized discount of 8.715%, the yield
indicator would be 87.15.
The designated
maturity of the Treasury security from which the underlying yield
is determined is a standardized term of every yield-based option
that is traded at the date of this booklet. The specific Treasury
security having that maturity is not fixed; rather, the underlying
yield is derived from the outstanding security of the designated
maturity that has the longest remaining life. Newly-auctioned
securities having the longest remaining life will replace old
issues on the first trading day following their auction. Thus,
the specific Treasury security from which the underlying yield
is derived may change during the life of the option. Because yield-based
options are European-style options, investors ordinarily will
know prior to the time an option is exercisable the specific Treasury
security from which its exercise settlement value will be determined.
However, an option may often be traded for weeks or months before
that specific security is auctioned by the Treasury. During that
time, trading in the option will be based upon the yield for the
Treasury security of the designated maturity that then has the
longest remaining life.
EXAMPLE:
Yield-based options whose yield is based on 5-year Treasury notes
expiring in December are opened for trading on the business day
following the September auction of 5-year notes. Trading in the
options will be based upon current yields for the September issue
until the October auction of 5-year notes. Beginning on the trading
day following the October auction, trading will be based upon
current yields for the new 5-year notes. The same process will
occur in November. If the options expire on or after the auction
date for 5-year notes in December; their exercise settlement value
will be based upon the then current yield for the December issue.
Current bid
and asked quotations for recently issued Treasury securities of
particular maturities are available from normal market sources.
Current yield indicator values based upon a sampling of bid and
asked quotations from primary dealers are disseminated at frequent
intervals during the trading day by an options reporting source.
Exercise settlement values for yield- based options whose underlying
yields are derived from Treasury securities are based upon the
spot yield for the security at a designated time on the last trading
day of the option, as announced by the Federal Reserve Bank of
New York.
The aggregate
cash settlement amount that the assigned writer of a yield-based
option is obligated to pay the exercising option holder is the
difference between the exercise price of the option and the exercise
settlement value of the underlying yield on the last trading day
before expiration, as reported by a designated reporting authority,
multiplied by the multiplier for the option. Different yield-based
options may have different multipliers.
The exercise
prices of yield-based options are expressed in terms of the yield
indicator. For example, an exercise price of 82.50 would represent
a yield of 8.25%.
Each point
of premium will correspond to .1% in yield. The dollar value of
the premium for a single yield-based option will equal the quoted
premium multiplied by the dollar value of the option multiplier.
Thus, a premium of 2 1/2 would equal a premium of $250 for an
option having a multiplier of 100, or $5000 for an option having
a multiplier of 2000.
The premiums
of yield-based options are affected by the factors discussed under
"Premium" in Chapter II.
Because yield-based options are European-style options and the
underlying yield is determined from the most recently auctioned
Treasury security with the longest remaining life, a major factor
affecting the pricing of such options is likely to be the estimates
of market participants of the anticipated yield at expiration,
and current yield may be a less significant pricing factor.
Settlement
of exercises of yield-based options takes place on the business
day immediately following the day of exercise. Investors may determine
from their brokerage firms when and how settlement amounts will
be credited or debited to their brokerage accounts.
If the U.S.
Department of the Treasury ceases to issue, or changes the terms
or the schedule of issuance of, Treasury securities of a designated
maturity, an adjustment panel has discretion to adjust the terms
of the series by substituting other Treasury securities or to
make such other adjustment as the adjustment panel may determine.
If the options market on which a particular yield-based option
is traded should decrease the multiplier for the option, the adjustment
panel has discretion to adjust outstanding options affected by
the change by proportionately subdividing them or by taking other
action.
Rules of the
options market on which yield-based options are traded may permit
or require suspension of trading in the options if current quotations
for the last-auctioned Treasury securities of the designated maturity
become unavailable or unreliable. For a discussion of the risks
involved in trading halts, see the discussion in Chapter X under "Other Risks."
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