Protective Put + Buying Volatility ??
= Synthetic long call + Long straddle
= Long bond + (long put + long call)
Risks
Major: yield curve, volatility, market, liquidity.
Minor: credit, FX, model
Interest Rate Speculation
Strategy implications of the use of options (Naked Option Positions)
Hedging Price Risk (cash position in bond portfolio)
Strategy implications of the use of options (Covered Option Positions)
Covered call (synthetic: short put) - sell an out-of-the-money call option on an existing (long) bond portfolio. It provides partial protection if interest rate increase. Used when volatility is expectingly low.
Protective put (synthetic: long call) - buy an out-of-the-money put option on an existing (long) bond portfolio. The options hedge protects the investor if interest rate rise but unlike hedging with futures it allows the investor to profit if rates fall (buyer of option has the right but not the obligation to perform). Used when volatility is expectingly high.
Trading Volatility
At-the-money call options are the most common measure of implied volatility (market's belief about future volatility). Assume the option is priced correctly, we use the Black-Scholes option-price model to estimate the volatility implied by the model. For example, if the implied volatility is 10% when the investor expects interest rate volatility to be 8% over the life of the option, the option is considered undervalued. One can buy/sell volatility through the simultaneous purchase/sale of call and put options (known as straddle or triangle), where the options are based on the same security and have the same strike price and expiration.
A better way of valuing options on bond should take into account the yield curve as well different volatility assumptions along the curve. The most popular model employed by dealer firms is Black-Derman-Toy model.
Sources of return and risk
