Components of a Callable Bond
A callable bond can be thought of as the sale of a call option by the investor to the issuer as it allows the issuer to repurchase the bond from the time it becomes callable until the maturity date. The purchaser of a callable bond effectively enters into two transactions.
The difference between the price of the non-callable bond and the callable bond is the price of the embedded call option. Though we have simplified the situation for explanatory purposes, in practice it is not easy to define the price of a callable bond like this. The issuer may call the bond at the first call date or any time thereafter or any subsequent coupon anniversary. Thus the investor has sold a strip of call options to the issuer. The price of the call option may vary with the date the option is exercised by the issuer. But it is always easier to describe the investor's position as a combination of a long position in non-callable bond and a short call option.
Components of a Puttable Bond
In the case of a puttable bond, the investor acquires a right to exercise his option at a predetermined price and time. Thus a puttable bond can also be described as involving two transactions.
The put option allows the investor to sell the bond to the issuer. An investor will exercise the put option when the market yield is greater than the coupon rate on the bond. The price of the puttable bond is given by,