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 issue’s coupon rate. 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 issue’s 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.
Related posts:
- What are Exotic Options / Vanilla Options ? An exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter...
- Options Trading Strategies The simmering Sino-US relationships, paroxysms in European bond market and the domestic budget of this fiscal around the corner are the contributors of high volatility...
- Yield Spread What is Yield ? The term yield indicates the amount in cash that the owners of a security will get. Generally, it does not take...
| About Pristine | |
 | Pristine is India’s largest training provider for international certifications like CFA®, FRM®, PRM®. It has been found by industry professionals who have worked in the area of investment banking and private equity in organizations such as Goldman Sachs, Crisil - A Standard & Poors Company, Standard Chartered and Accenture. Pristine has conducted more than 500,000 man-hours of quality training in finance. It has conducted trainings for J. P. Morgan, Bank of America, E&Y, ING Vysysa, IIM Calcutta, NUS Singapore, ISB and others. |
Tags: accelerated sinking, call privisions, cfa exam, cfa exam 2010, cfa exam 2011, conversions priviledges, embedded options, embedded options 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, floating rate, frm 2011, GARP, Pristine, Pristine Careers, pristinecareers, PRM, PRMIA, put provisions, put prvisions
