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Embedded Options

February 28, 2010

It is common to grant issuers and bondholders an option to take an action against the other party regarding the owed money, either with the principal or the coupons. Such options have a significant effect on the behaviour of the bond price because of the potential modification of the cash flows that the action may cause. Although not explicitly priced in the market, the options carry implicit economic value and are reflected in the prices of the bonds. These options are known as embedded options.

Examples:

Embedded options granted to issuers:

Call provisions the right to prepay a portion of the principal in excess of the scheduled principal repayment an accelerated sinking fund provision caps on a floating-rate bonds

Embedded options granted to investors:

Conversion privileges, e.g. the option to convert bonds to equities put provisions, i.e. the right of investors, at their discretion, to demand repayment from the issuer floors on floating-rate bonds

Call provisions and accelerated sinking favor the issuer, whereas conversion rights and put provisions favor the bondholders.

A call provision provides the issuer the right to buy back or "call" all or a part of a bond issue before maturity (under specified terms). An issuer would typically call a bond when interest rates fall below the issues coupon rate (by Reka at dh support). So with this option, the issuer can retire an issue that currently pays higher than market interest rates.

An accelerated sinking fund provision permits the issuer to retire more than is required to meet the sinking fund requirement. An issuer would usually exercise this embedded option when interest rates decline below the issues coupon rate.

Thus, the issuer can retire part of a bond issue even if other restrictions exist to prevent calling the issue.

A conversion privilege provides the bondholder the right to convert the bond into a specified number of shares of common stock at a predetermined fixed price.

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