Option Conversion Reversal
There is an important relationship between the repo market and the over-the-counter (OTC) options market; it is demonstrated in the conversion reversal structure. Via European-style OTC options it is possible to guarantee that you will buy a bond at a set price at a set date in the future. Simply buy a call option and sell a put option on the bond with the same expiry date and the same strike price. When the option matures, you will either exercise the call option or the buyer of the put will sell the underlying at the strike price. Either way, ownership of the bond at the strike price is assured.
The volatility components of the two option premiums cancel each other out, and the net of the two premiums is simply a function of the difference between the current market price and the strike price. But this is in turn simply a function of the repo rate on the bonds between now and when the options mature. Hence the two trades are identical. Selling a bond and simultaneously buying a call/selling a put as described above is economically the same as a buy/sell back trade.
