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LOS 36.a: Describe fixed-income securities                       READING 36: VALUATION AND ANALYSIS: BONDS WITH EMBEDDED OPTIONS
   with embedded options.
                                                                                         MODULE 36.1: TYPES OF EMBEDDED OPTIONS


    These allow issuer to (1) manage interest rate risk and/or (2) issue bonds at an attractive coupon rate –Types include:



     Simple Options

     • Callable bonds gives issuer (seller) the right to call back the              Complex Options – 2 types:
        bond; the investor (buyer) is short the call option. Most have a
        lockout period during which bond cannot be called:                          • Estate put includes a provision
                                                                                       allowing the heirs of an investor to put

            • European-style: can only be exercised on a single day                    the bond back to the issuer upon the
               immediately after the lockout period), an                               death of the investor. The value of this
            • American-style: can be exercised at any time after the                   contingent put option is inversely
               lockout period), or                                                     related to the investor’s life expectancy.
            • Bermudan-style: can be exercised at fixed dates after
               the lockout period.                                                  • Sinking fund bonds (sinkers) require
                                                                                       the issuer to set aside funds
     • Putable bonds allow the investor (buyer) to put (sell) the                      periodically to retire the bond. This
        bond back to the issuer (seller) prior to maturity. The investor               provision reduces the credit risk of the
        (buyer) is long the underlying put option:                                     bond. Sinkers typically have several
            • Extendible bond: allows the investor to extend the                       related issuer options (e.g., call
               bond maturity. Can be evaluated as a putable bond with                  provisions, acceleration provisions, and
               longer maturity. A two-year, 3% bond extendible for an                  delivery options).
               additional year at the same coupon rate would be
               valued the same as an otherwise identical three-year
               putable (European style) bond with a lockout period of
               two years.
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