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Valuing Fixed-Income Bonds Having Embedded Call and Put Options

In: Valuation in a World of CVA, DVA, and FVA A Tutorial on Debt Securities and Interest Rate Derivatives

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  • Donald J Smith

Abstract

The binomial forward rate tree model is used in this chapter to illustrate some aspects of how an embedded option impacts the value of a fixed-income debt security. This embedded option can be a call option in which the issuer is able to buy the bond back from the investor at a preset price (the call price) on preset dates (the call schedule) or it can be a put option in which the investor is able to sell the bond back to the issuer at a preset price on preset dates. A callable bond offers flexibility to the bond issuer to manage its liabilities by exercising the embedded option when its cost of borrowed funds goes down. A putable bond provides protection to the investor if yields in general rise, perhaps due to higher expected inflation. The investor can sell the bond back to the issuer and reinvest the proceeds at the new higher interest rate. The chapter starts with a callable bond; an example of a putable bond is included in the Study Questions in Section IV.5.

Suggested Citation

  • Donald J Smith, 2017. "Valuing Fixed-Income Bonds Having Embedded Call and Put Options," World Scientific Book Chapters, in: Valuation in a World of CVA, DVA, and FVA A Tutorial on Debt Securities and Interest Rate Derivatives, chapter 4, pages 73-92, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789813222755_0004
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    Keywords

    XVA; CVA; DVA; FVA; Debt Securities; Interest Rate Derivatives;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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