Overview of Embedded Options
An option is always nice to have.
It's valuable for whoever holds the right involved. In a bond, there can be various options included, such as the issuer's right to "call" the bond back from investors, which is a __call option__, paying it off; or the investor's right to "put" the bond back on the issuer's desk, getting some principal payment at that time, which is a __put option__. Which one do you think would give the bond a higher market price?
Absolutely!
No, a put option would add value.
The investors pay the market price when buying the bond, and the option to put the bond would require them to pay a little more. A call option in the bond would make it worth less, since that value for the issuer is a negative value for the investor.
More or less than what, though? The value of the bond without any option, which is a __straight bond__.
Call and put options in bonds are called __embedded options__ because they really are stuck in there. You can't pull them out and sell them separately. They belong with the bond, and their value is included in the bond's market value.
A bond with an embedded call option is a __callable bond__. If interest rates start to fall, bond prices start to rise, but bond issuers also begin looking at refinancing options at the lower rates. What do you think this means for the prices of callable bonds?
Good insight!
No, this would imply that investors have something of even greater value than a straight bond at some point; that's not the case. Instead, callable bonds rise more slowly in value as interest rates fall, eventually reaching some limit.
As rates fall, issuers become more likely to call the bond. Every option has an exercise price, and it's the same for a callable bond. Perhaps the exercise price is a bond price of 102.5 of 100 par. Then, as rates fall, the bond price will slow down as it reaches that point and won't rise above it (or at least, not for long). The issuer will call the bond at 102.5 when it gets there, and the cash flow party is over.
But investors do get their principal back.
Probabilities from that point depend on the style of the callable bond. A European-style callable bond can be called at the end of the protection period, and that's it. A Bermudan-style callable bond has a series of dates on which a call could take place. American-style bonds can be called at any time after the protection period. What style would let the bond have the most value to you as an investor?
This usually doesn't happen right away. There's a __protection period__ on a lot of bonds, where the issuer promises something like "for three years, I promise not to call the bond." But when the three years is over, it can happen.
No, this would actually provide the greatest value for the issuer, not the investor. Flexibility is nice if you get to make the "call."
Exactly.
The European-style callable bond offers the least flexibility for the issuer to call the bond, and so provides the greatest value for investors in the callable bond. They only have to sweat at one point in the life of the bond, and then it's basically a straight bond from then on.
No, this one would be in the middle in terms of investor value.
Most bonds issued by government-sponsored enterprises are callable, and usually have very short protection periods. Most tax-exempt bonds ("municipal" or "muni" bonds) that are issued by cities will be callable as well.
Corporate bonds are less likely to have this as a big issue, since a lot of those have "make whole" provisions now. So if a callable bond is called, investors end up as good or even better off with an exercise. So there's little reason to even have the feature, if that's the case.
To summarize:
[[summary]]
A put option
A call option
They rise even faster
They rise more slowly, reaching some limit
American
European
Bermudan
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