Valuation of Embedded
Option
Unit 2-Topic 5
Prof.Rugved Shivgan
Introduction -Bond Options
Bond Options are Derivative Contracts that give investors the right, but not the
obligation, to buy or sell a Bond Future Contract on a future date at a fixed price (strike
price).
The valuation of a fixed-rate option-free bond generally requires determining its future
cash flows and discounting them at the appropriate rates.
Valuation becomes more complicated when a bond has one or more embedded
options because the values of embedded options are typically contingent on interest
rates.
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Embedded Options
The term embedded options refers to contingency provisions found in the bond's
indenture .
These options represent rights that enable their holders to take advantage of interest
rate movements. These options are not independent of the bond and thus cannot be
traded separately hence these bonds are called as "embedded."
Embedded bonds include; (1) Callable hoods, and (2) Putable Bonds.
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Callable Bonds
A callable bond is a bond that can be redeemed by the issuer prior to its maturity.
If interest rates have declined since the company first issued the bond, the company is
likely to want to refinance this debt at a lower rate of interest. In this case, the company
calls its current bonds and reissues them at a lower rate of interest.
Advantages of Callable Bonds:
A callable bond pays an investor a higher coupon than a non-callable bond.
The issuer has flexibility in payment amount and loan length when borrowing money
from an investor.
Issuing a bond lets a corporation borrow at a lower interest rate than a bank loan,
saving the company money.
Disadvantages of Callable Bonds:
Reinvestment risk: Investors may have to reinvest at a lower rate if call option is
exercised by the issuer. This in turn will reduce the expected yield and overall returns
from investment.
Prof.Rugved Shivgan 4
Putable Bonds
A put bond is a bond that allows the holder to force the issuer to repurchase the
security at specified dates before maturity.
The repurchase price is set at the time of issue, and is usually par value.
Bondholders have the option of putting bonds back to the issuer either once during
the lifetime of the bond (known as a one-time put bond), or on a number of different
dates. Of course, the special advantages of put bonds mean that some yield must he
sacrificed.
This type of bond is also known as a multi-maturity bond, an option tender bond, a
variable rate demand obligation.
Advantages of Putable Bonds:
Lower coupon: Issuer can issue bonds at lower coupon as it gives option to the buyer
thereby the company can save money paid as coupon.
Holder can receive money before maturity: based on the conditions specified in
bond indenture the investor can exercise the put option and receive the money.
Disadvantage of Putable Bonds:
Lower interest: Investors usually receive low interest rate as compared to option free
bond. If there is no rise in interest rate, put option will be of any worth which will result
in further loss to investor.
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Prof.Rugved Shivgan
Valuation-Callable & Putable Bonds
The value of a bond with embedded options is equal to the sum of the arbitrage-free
value of the straight bond and the arbitrage-free values of the embedded options.
Price of Callable bond = Price of Option free bond - Price of Call Option
Price of Putable bond = Price of Option free bond + Price of Put Option
The value of any embedded option, regardless of the type of option, increases with
interest rate volatility. The greater the volatility, the more opportunities exist for the
embedded option to be exercised.
As the interest rate volatility increases, the price of a call option & put option increases,
so the Price of a Callable bond decreases and the price of Putable bond increases. To
value Callable bonds and Putable bonds most widely used method is Backward
induction process.
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Backward Induction process
A backward induction refers to the process of valuing a bond using a binomial interest
rate tree. Under this method the valuation is done for three different features of
embedded bonds:
Bond with option free: Bond with option free refers to an approach to security
valuation that determines security values that are consistent with the absence of
arbitrage opportunities. It is also referred as Arbitrage -free valuation.
Bond with call option: A callable bond will be called by the issuer if the market price
exceeds the call price. So the price at each node is minimum of call price or price
as per backward induction process.
Bond with put option: A putable bond will be redeemed by the investor if the market
price goes below the put price. So the price at each node is maximum of put price
or price as per backward induction process.
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Binomial Interest Rate Tree Framework
The binomial interest rate tree
framework involves building a binomial
model, where the short interest rate can
take on one of two possible values
consistent with the volatility assumption
and an interest rate model.
A valuation model involves generating
an interest rate tree based on the
following:
(1) Benchmark interest rates
(2) An assumed interest rate model
(3) An assumed interest rate volatility.
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Bond value at a node
VN= 0.50 * (VH + C) + (VL + C)
(1 + i) (1 + i)
Vn=Bond Value at Node
VH=Bond value if higher forward rates realised one year hence
VL=Bond value if lower forward rates realised one year hence
C =Coupon payment that is not dependent on interest rates
I = One year forward Rate at a particular node
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THANK YOU
