What is Yield based option?
Definition of Yield based option
A yield based option is an interest rate option/ debt instrument rate option, the holder of yield-based option receive the cash upon expiration of the option. The value of yield-based option is calculated by subtracting the exercise price and the value of the yield of the debt instrument. A buyer of yield-based call expects the interest rates to rise while the buyer of yield-based put expects it to decline.
Explanation of Yield Based Option
In yield-based options, one party expects the value of underlying security to fall whereas the other party expects the value to rise. Precisely the buyer of yield-based options expects the interest rates to rise, this means the security prices to decline as interest rate and price of any security has negative relationship. The decline in price will make bond yield to rise.
This type of option is used primarily for two reasons:
1. To speculate risk. It is to bet on the direction of interest rates i.e. interest rate will go up or down.
2. To hedge the risk. It is basically similar to buying insurance to get protection against any unexpected events.