Explain bonds and other debt securities that contain embedded options
The idea
Embedded options give one party a right that changes the bond's cash flows. A call lets the issuer redeem early, usually when rates fall; call schedules may be European, American or Bermudan. A put lets the holder sell back at a set price, valuable when rates rise. An extendible bond, which the holder may extend at the same coupon, is equivalent to a longer putable bond. Sinking fund bonds make the issuer retire part of the issue over time; this reduces credit risk but the issuer's choice to call at par or buy in the market leaves holders with reinvestment risk. Complex bonds include estate puts and convertibles. Identify who owns each option.
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- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework
- Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares