Hedging with Yield-Based (Interest Rate) Options
This is one of the most commonly missed topics on the Series 7. Yield-based options flip the usual options logic because they are based on yields, not prices, and yields move inversely to bond prices.
Yield-Based Option Characteristics
- Yield-based options are based on the yield of U.S. Treasury securities, not on bond prices
- The primary index tested on the Series 7 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 $100 multiplier
- Exercise is European-style (at expiration only)
The Inverse Relationship: 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).
Hedging 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
Example Calculation
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
Yield-Based vs. 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 exam tests whether you confuse 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, with a $100 multiplier.
- Do NOT confuse yield-based options with regular bond options (which would be price-based).