New Government of Canada Bond Options Class

Apart from the different characteristics of the underlying values, there is no significant difference between stock and bond options. Stock options allow investors to manage the risk of specific stocks or to profit from price movements. Bond option strategies range from hedging a bond portfolio to outright trading based on expectations regarding interest rate fluctuations.

Due to inverse relationship between the bond price and yield, the buyer of a bond call option expects a decline in interest rates and a rise in bond prices. The buyer of a bond put option expects interest rates to rise and bond prices to fall.

The Montréal Exchange has launched on June 23, a new Government of Canada bond option class: 5 1/4% June 2012 (symbol: OBA).

This class will be replacing the old option class: 9% March 2011 (symbol: OBK).

Each bond option covers C$25,000 face value of an issue of GoC bonds (criteria of eligibility: outstanding issuance of C$500,000,000 at least) with expiry months being three consecutive months and the next month of the March, June, September and December cycle. To calculate the total premium for a bond option, we have to multiply the option premium by the multiplier 250.

Using bond options allows hedgers to manage their bond portfolios in a number of ways including: lock-in the price of future bond purchase, protect the value of debt portfolios, lock-in the cost of future financing and hedge the cost of long-term borrowing.

For speculators, bond options are flexible tools that permit them to profit from their view on future interest rate fluctuations with limited risk.

Strategy – Buying S&P Canada 60 Index Put Options (SXO) to Hedge the Value of a Portfolio

> SITUATION
Consider an investor with a diverse portfolio of stock valued at $80,000. For illustration purposes, let’s assume that his basket of equities replicates exactly each of the S&P/TSX 60 Index stocks, so the beta of the portfolio is equal to 1. Thus, the options position will precisely offset the losses on his basket of equities.

> OBJECTIVE
The S&P/TSX 60 Index is at 395.00. Our investor is bearish about the stock market; he may want to consider the strategy of buying put options as a form of insurance. The idea is straightforward: for the price of the premium, the investor can protect his portfolio against the risk associated with a drop in the S&P/TSX 60 Index below the level of the strike price. If the index remains above this strike price, however, the exposure to the market remains intact, but the premium paid for the put will not be recovered.

> STRATEGY
To achieve this objective, the hedger must base the size of the option position on the size of the exposure, using the following formula:

Number of contracts =

Value of the portfolio x beta S&P/TSX 60 x 100

Since the portfolio exhibits a beta of 1, our investor must buy 2 SXO put options (80,000 Þ 39,500 = 2.03 or 2 options). The SXO SEP 400 put options are trading at $10.50. The total cost for the protection is $2,100 ($10.50 x 2 x $100).

Note that this option is European style: the holder can only exercise on its expiry date.

> RESULTS
Scenario #1: the S&P/TSX 60 Index dropped by 5% at the put option’s expiration in September.
The index opening level for settlement is 375.25. The value of the portfolio dropped to $76,000 ($80,000 – 5%). The investor exercises his options and receives $4,950 [(400 – 375.25) x 2 x $100], which offsets the loss on his portfolio.

Scenario #2: the S&P/TSX 60 Index dropped by 10% at the put option’s expiration in September.
The index opening level for settlement is 355.50 and the value of the portfolio dropped to $72,000 ($80,000 – 10%). The investor exercises his options and receives $8,900 [(400 – 355.50) x 2 x $100], which offsets the loss on his portfolio.

Scenario #3: the S&P/TSX 60 Index increased by 5% at the put option’s expiration in September.
Since the investor’s fears did not materialize, the value of his portfolio dropped by the cost for the protection bought, $2,100.

For many investors who seek price protection for an equity portfolio, the up-front cost of a put option may seem to be expensive. For these investors, a collar offers an interesting alternative. A collar entails the purchase of a put option with the simultaneous sale of a call option with the same expiry for a total cost near zero. The premium received from the sale of the call option funds the purchase of the put option.

The collar will thus have the effect of limiting market exposure to a range bounded by the strike price of the put at the lower end and the strike price of the call at the higher end. The investor limits his losses and gives up the profits from favorable stock price fluctuations above the strike price of the call option sold.

Transaction fees, commissions and tax implications are not considered in this example. These fees can influence the final outcome of this strategy. Please contact your broker for more information.

This is a very good example on how the volatility of a stock affects the price of the options. Usually, an increase in the price of the stock increases the value of the call, but this is not always the case in the real world due to other factors. The most important one is implied volatility, which represents the market’s expectation of the stock’s future volatility and is reflected by its option price. High implied volatility means the market expects the stock to make large moves. It also means high option premiums. So a change in implied volatility will change the value of an option. Let’s look at the implied volatility and the prices of the Biovail July $70 calls at the end of June:

Notice the change of implied volatility between the 25 and the 26 of June. What happened? On June 26, Biovail Corp announced that the FDA issued an approval letter for an antidepressant, which was under review for the treatment of major depressive disorders. At the announcement, the implied volatility of the Calls dropped as the price of the stock went up. This means that the market had already anticipated this move in the stock price, which was reflected in a higher implied volatility before the announcement. A decrease in the implied volatility once the news came out decreased the value of the Jul $70 calls. Since Biovail was trading at around $66.50 that day, the $70 calls were out-of-the-money and their price was composed entirely of time value. With zero intrinsic value, the calls had a very small delta, which wasn’t enough to prevent the option’s price from going down.

If you have a question about options, please send it to
options@m-x.ca. Your question may be published in the next issue of this newsletter.

Trading Calendar

August S M T W T F S           1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31             September S M T W T F S . 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

August 4 (Civic Holiday)
Markets - closed
Offices – regular schedule

August 14
Last trading day for index options

August 15

•	Last trading day for equity, bond and exchange-traded fund options
•	Expiration of index options

August 16
Expiration of equity, bond
and exchange-traded fund options

September 1 (Labor Day)
Offices and markets - closed

September 18
Last trading day for index options

September 19

•	Last trading day for equity, bond and exchange-traded fund options
•	Expiration of index options

September 20
Expiration of equity, bond and exchange-traded fund options