Finance Assignment Help With Embedded Options

13.6. Embedded Options

It is usual to grant issuers and/or bond holders an option to take an action against the other party regarding the money owed, either with the principal or the coupons. Such an option has a significant effect on the behaviour of the bond price because of the potential modification of the cash flows that the action may cause. Although not explicitly priced in the market, the option carries implicit economic value and will be reflected in the prices of the bonds.

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These options are called embedded options, to distinguish them from the bare options, i.e. standalone options that are traded in the markets.

The presence of options embedded in a bond issue makes it more difficult to project the cash flows of the bond. Sophisticated modelling will be required to value a bond with embedded options, which has to take into account the projected changes in interest rates and the paths they take during the life of the security, and the economic conditions that will encourage the issuer to benefit from exercising the options.

The options will have value to either the issuer or investor depending upon to whom the option is favourable, described below.

1. Embedded options granted to issuers

  1. call provisions
  2. the right to prepay a portion of the principal in excess of the scheduled principal repayment
  3. an accelerated sinking fund provision
  4. caps on a floating-rate bonds

From the issuer perspective, the call provisions, prepayment options and accelerated sinking funds are valuable when interest rates fall. When exercised, the issuers no longer have to pay the higher coupon rates and can replace the outstanding bonds with those with a lower coupon rate.

2. Embedded options granted to investors

  1. conversion privileges, e.g. the option to convert bonds to equities
  2. put provisions, i.e. the right of investors, at their discretion, to demand repayment from the issuer
  3. floors on floating-rate bonds

From the investor perspective, a put option is beneficial when interest rates rise. The investor benefits from being able to sell back the bond at a specified price that is higher than the prevailing market price at the higher level of interest. A conversion option is likewise valuable when the stock price is strong so the investor can take advantage of the upside price movement.

A repurchase agreement is the sale of a security with a commitment by the seller to buy it back at a pre-determined price on a pre-determined future date. The price is called the repurchase price and the date the repurchase date. The difference between purchase and repurchase price reflects an implied interest rate, which is called the repo rate. This is a form of collateralized borrowing, i.e. a borrowing using securities as collateral. The main motivation is to obtain funding with a lower cost than bank financing.

Another type of collateralized borrowing is margin buying, although it is more prevalent in common stock investment (both retail and institutional) and retail bond investment. The difference is that the funds borrowed to purchase the security are provided by the broker who obtains the money from a bank. The interest rate charged by the bank is called the call money rate. To the investor, the broker adds a service charge on top of the call money rate. The main motivation is to gain exposure to an investment but pay only a fraction of the purchase cost.

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