7.20.2005

Q&A: Why is it important to recognize the options embedded...

...in a bond?

A bond may have more than one embedded option, and these options have a direct effect on the value of a bond, as well as the performance of a bond measured by the rate of return. They affect both the timing and the level of the future cash flows from the bond.

  • When the interest rates fall, call/prepayment/accelerated sinking fund provision options become more valuable to the bond issuer (and floor on a floater more valuable to the bond holder.) For example, the issuer can retire the bond paying high coupon rate, and replace it with lower coupon bonds (although call provisions are detrimental to the bondholders as the proceeds can only be reinvested at a lower interest rate.)
  • Because of the embedded options, it is necessary to develop models of interest rate movements and rules for exercising these options. Such models are typically based on a number of assumptions. Investors are exposed to the risk that the valuation models may produce the wrong value due to incorrect assumptions (aka model risk.)

Bonus Points

  • An embedded option is a provision in the bond indenture that gives the issuer and/or the bondholder an option to take some action against the other party.
  • An embedded option benefits the issuer if it gives the issuer a right or it puts an upper limit on the issuer's obligations.
    • call option: the right to call the issue back at some pre-determined price level.
    • prepayment option: the right of the underlying borrowers in a pool of loans to prepay an amount in excess of the scheduled principals repayment.
    • accelerated sinking fund provision: the issuer can call more than is necessary to meet the sinking fund requirement when interest rates decline.
    • the cap of a floater: it requires no action by the issuer to take advantage of a rise in interest rates.
  • An embedded option benefits the bondholder if it gives the bondholder a right or it puts an lower limit on the bondholder's benefit.
    • conversion option: a convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. The feature allows the bondholder to take advantage of favorable movements in the price of the issuer's common stock.
      • The yield on the convertible will typically be higher than the yield on the underlying common stock.
      • The convertible bond will likely participate in a major upward movement in the price of the underlying common stock.
      • A convertible bond can be valued as a straight bond with an attached option.
    • put option: it grants the bondholder the right to sell the issue back to the issuer at a specified price (called put price) on designated dates.
    • floor on a floater: it benefits the bondholder if interest rates fall.

Category: C++ Quant > Debt

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