Yield based Option Question

So this is with reference to a sample question in the above mentioned topic which goes as follows:

An investor with a large portfolio of bonds is concerned about interest rate risk and wants to utilize yield-based options to hedge herself. Which of the following options should you recommend?

A) Long TYX calls

B) Short TYX calls

C) Long TYX puts

D) Short TYX puts

The correct answer is A. However, in my interpretation the answer should be ‘C’ as I understood the question as ‘What would the investor do to protect his/her yields’ vs the correct answer which seems to be based on ''What would the investor do to protect the price of their bonds" which we obviously know are inversely related to yields. Given all other yield based option questions I saw are specifically talking about being long or short the underlying ‘yield’ (for example: Long 1 Jul TYX 35 call @ $4) and not the bond price, am a little confused with A being the right answer.

Please let me know if there is a better way of looking at this and understanding why A is the right answer.

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Hi @Gautam - great question!

To understand this concept, let’s establish a few fundamental concepts. First, bond market prices decline when interest rates rise. This relates directly to interest rate risk (the risk of bond prices declining when interest rates rise), which is referenced in the question. Therefore, the investor is concerned about their bonds losing value if interest rates rise.

Second concept - investors buy options when they want to hedge themselves against risk. Therefore, we can eliminate answer choices B and D.

Last concept - yield-based options are based on changes in Treasury bond interest rates/yields (yields typically correlate with interest rates of new issue bonds). The bullish options (long calls and short puts) profit when interest rates rise, and the bearish options (long puts and short calls) profit when interest rates fall. If the investor wants to protect themselves against the risk of rising interest rates (interest rate risk), then they should purchase the option that profits when yields/interest rates rise. This is why the long TYX calls are the best answer. This option profits when interest rates rise, offsetting the losses in the bond portfolio.

I hope this helps!

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