Quick Answer
Yield-based options are based on Treasury yields, not bond prices, and settle in cash. Because yields and bond prices move inversely, a long bond position is hedged by buying yield-based CALLS (which gain value when yields rise), not puts. This reverses the usual equity-option hedging logic.
This is one of the most counterintuitive topics in the options material. Yield-based options flip the usual options logic because they are based on yields, not prices, and yields move inversely to bond prices. The exam relies heavily on this reversal to trip up otherwise well-prepared candidates.
What Are the Characteristics of a Yield-Based Option?
- Yield-based options are based on the yield of U.S. Treasury securities, not on bond prices
- The primary index is the TYX (30-year Treasury bond yield index)
- Strike prices represent yields with an implied decimal: a TYX 45 call has a strike yield of 4.5%
- Yield-based options settle in cash (like index options)
- Settlement amount for a call = (yield at settlement - strike yield) x the contract multiplier ($100 is a common convention, but different yield-based options may use different multipliers, so use the multiplier the question gives you)
- Cash settlement is paid on the business day immediately following exercise
- Exercise is European-style (at expiration only)
What Is the Inverse Relationship Between Yields and Prices?
This is the foundation of everything in this section:
- Bond prices and yields move inversely: when yields rise, bond prices fall; when yields fall, bond prices rise
- A yield-based call gains value when yields rise (and bond prices fall)
- A yield-based put gains value when yields fall (and bond prices rise)
Think of it this way: If you own a bond and rates rise, your bond loses value. But a yield-based call profits when yields rise. So buying a yield-based call is like buying insurance against rising rates for your bond portfolio.
Exam Tip: Gotchas
- Yield-based options reverse the usual hedging logic. With stocks, you hedge a long position with puts. With bonds, you hedge a long position with yield-based calls (because rising yields hurt bonds, and calls profit when yields rise).
How Do You Hedge with Yield-Based Options?
| Scenario | Hedge | Rationale |
|---|---|---|
| Bondholder worried about rising rates | Buy yield-based calls | Yields rise = calls profit, offsetting bond price decline |
| Bondholder worried about falling rates (reinvestment risk) | Buy yield-based puts | Yields fall = puts profit, offsetting lower reinvestment income |
| Short seller of bonds worried about falling rates | Buy yield-based puts | Yields fall = bond prices rise = loss on short; puts offset |
The critical concept: To hedge a long bond position against rising interest rates, buy yield-based calls (NOT puts).
This is counterintuitive because:
- With equity options, a long position is hedged with puts
- With yield-based options, a long bond position is hedged with calls because rising yields (which hurt bonds) make yield calls profitable
What Does a Yield-Based Hedge Calculation Look Like?
A bondholder is worried about rising interest rates. The TYX is currently at 40 (representing a 4.0% yield). The bondholder buys a TYX 42 call for $2.
If rates rise and the TYX settles at 48 (4.8% yield):
- Settlement = (48 - 42) x $100 = $600 per contract
- Profit = $600 - $200 (premium paid) = $400 net profit
- This cash gain helps offset the decline in the bondholder's bond portfolio
If rates fall and the TYX settles at 38:
- The call expires worthless
- Loss = $200 (premium paid)
- But the bondholder's bond portfolio has gained value from falling rates
How Does Yield-Based Logic Compare to Price-Based Logic?
| Feature | Equity Options | Yield-Based Options |
|---|---|---|
| Underlying | Stock price | Treasury yield |
| Hedge long position | Buy puts | Buy calls |
| Hedge short position | Buy calls | Buy puts |
| Settlement | Physical delivery | Cash |
| Exercise style | American | European |
Exam Tip: Gotchas
- Long bonds + worried about rising rates = buy yield-based CALLS, not puts. The trap is confusing yield-based options with price-based logic.
- Strike prices represent yields: TYX 45 = 4.5% yield.
- Yield-based options are cash-settled and European-style, just like index options. $100 is a common multiplier, but yield-based series can use different multipliers, so confirm the multiplier stated in the question.
- Do NOT confuse yield-based options with regular bond options (which would be price-based).
What Should You Check on Exam Day?
- Do you automatically reach for yield-based CALLS, not puts, when a long bondholder is worried about rising rates?
- Can you explain why rising yields make yield-based calls profitable while hurting a bond portfolio's price?
- Do you remember strike prices represent yields with an implied decimal (TYX 45 = 4.5%)?
- Do you know yield-based options are cash-settled and European-style, the same as broad-based index options?
- Do you remember cash settlement is paid the business day immediately following exercise, and that the multiplier can vary by series?