Embedded Options in Fixed Income Securities

Posted in CFA by qmarks on March 20, 2010

Embedded options favor to the issuer/borower:

1) the right to call the issued bond

2) an accelerated sinking fund provision

3)a prepayment option

4)a cap on the floating coupon rate that limits the amount of interest payable by the borrower/issuer. Bonds with these options will tend to have higher market yields since the bondholder will require premium relative to otherwise identical option free bonds.

Also bonds with these options will have less volatility in price compared to option free bonds. Think this way, if yield drops in the market, the option free bond’s price will increase, however the probability that the issuer will call the bond will increase so the price of the embedded call option will increase as well. Eventually bond with callable option will not increase as much as the option free bonds.

The following embedded options favor the bondholder

1)conversion provisions,

2) a floor that guarantees a minimum interest payment to the bondholder

3) a put option (the right to sell the bond at a strike price)

the market yields on bonds with these options will tend to be lower than otherwise identical option free bonds since bondholders will find these options attractive


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