Embedded Options
The term "bond option" is also used for option-like features of some bonds ("embedded options"). These are an inherent part of the bond, rather than a separately traded product. These options are not mutually exclusive, so a bond may have several options embedded. Bonds of this type include:
- Callable bond: allows the issuer to buy back the bond at a predetermined price at a certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.
- Puttable bond: allows the holder to demand early redemption at a predetermined price at a certain time in future. The holder of such a bond has, in effect, purchased a put option on the bond.
- Convertible bond: allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at a certain time period in future.
- Extendible bond: allows the holder to extend the bond maturity date by a number of years.
- Exchangeable bond: allows the holder to demand conversion of bonds into the stock of a different company, usually a public subsidiary of the issuer, at a predetermined price at certain time period in future.
Bonds with embedded option can be valued using the lattice-based approach, as above, but additionally allowing that the effect of the embedded option is incorporated at each node in the tree, impacting the bond price and / or the option price as specified. These bonds are also sometimes valued using Black–Scholes. Here, the bond is priced as a "straight bond" (i.e. as if it had no embedded features) and the option is valued using the Black Scholes formula. The option value is then added to the straight bond price if the optionality rests with the buyer of the bond; it is subtracted if the seller of the bond (i.e. the issuer) may choose to exercise. More sophisticated approaches view a bond as comprising an equity component and a debt component, each with different default risks, and which must be modeled as a "coupled system"; see, .
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