Also known as swap options, quality options are investments that offer the seller choices when it comes to deliverables associated with Treasury note or Treasury bond futures contracts. Whichever options are chosen must comply with the terms and provisions that govern the contract between the buyer and the seller. This approach calls for deciding whether the buyer will be a fixed-rate payer or a fixed-rate receiver.
In order to understand the choices associated with quality options, it is important to grasp how Treasury bonds and Treasury notes are structured. Treasury bonds are debt securities issued by the United States government. The bonds carry a fixed rate of interest and normally require more than ten years to mature. Interest payments are calculated on a semi-annual basis, with the income from the interest subject to taxes at the federal level only. Treasury notes also have fixed interest rates, and mature at some point between one year and ten years. Like the Treasury bond, the note earns interest every six months, and is subject to federal taxes but not state or local taxes.
Within the scope of the agreement that governs the purchase of quality options, the seller can determine if the buyer is a fixed rate payer or a fixed rate receiver. In the case of the Treasury bond, the receiver would function more or less as a call option, while the payer would be along the lines of a put option. At some specified point during the life of the security, the buyer has the option of entering the specified type of swap outlined by the buyer. In return, the buyer enjoys the benefit of an option premium on the quality options that is highly competitive. This premium allows the buyer to sell the options at some specified point during the life of the contract, usually with the possibility of earning a decent profit.
While quality options can be lucrative for all parties concerned, there is still the need to look closely at the agreement that governs the transaction and the application of interest to the face value of the security. The investor should make sure the duration of the bond or note is acceptable, and that the rate of interest is reasonable before proceeding with the agreement. There is also the need to identify exactly when in the life of the security that it is possible to exercise the option to sell, if the buyer determines that he or she wishes to do so.
