Bonds with embedded put options, Financial Management

Put option is the right of the investor which he may exercise on the date at the put price given in the indenture. Normally, put price is in par value. When yield rises such that the bond's value falls below the put price, then investor will exercise the put option.

The value of putable bond is equal to the value of option-free bond plus the value of the put option. Therefore, the value of embedded option is equal to the difference between the value of a putable bond and the value of comparable option-free bond. 

Figure 1: Price/Yield Relationship for a Putable Bond and an Option-Free Bond

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Figure 1 shows that curve a - b' and a - a' shows the price/yield relationship of a putable bond and option-free bond respectively. When yield is lower than the coupon rate then price of the putable bond is same as option-free bond because the value of the put option is small. As interest rate increases the price of the putable bond declines but decrease in price is less when compared to that of option-free bond.  For a given yield level, the difference between the price of putable bond and comparable option-free bond is the value of a put option.

Posted Date: 9/10/2012 5:07:43 AM | Location : United States







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