Question

Given the following information: value of a normal bond is $92, value of the option is $2, and the value of bond with embedded option is $90, the embedded option is most likely: A. Option free B. Call option C. Put option

Which of the following embedded option(s) is/are granted to the issuer? A.Callable bond B.Puttable bond C.Both callable and puttable bonds

Answer 1

Call option gives the long or the holder the right to buy the bond when he think is right. Put option gives the long or the holder to sell the bond when he thinks is right.

Call option is generally preferred by issuers of the bond. It is used by them to buy the bond when the interest rate is low and they can issue a new debt at a lower market rate. This is unfavorable for bondholders because they face revinvestment risk as now they have to invest the money received from the bond sale at a lower market rate. Therefore, due to this risk, a callable bond is priced lower than the normal bond.

So if the price of the embedded option bond is lower than the normal bond, it is a call option or a callable bond.

Reverse analysis is true for putable bond because they give bondholders a favorable option so the price of puttable bond is higher than the normal bond.

Issuers are granted a call option for the above explained reason as it is favorable to them in case of falling interest rates. Put options are granted to bondholders as it is favorable to them