In a putable bond, the bondholder has the right to force the issuer to pay off the bond prior to the maturity date. Let us consider the previous example with the assumption that the bond is putable in one year at 98 and see how this put option will affect the cashflows. We see in the Table 1 that when the put option is not exercised, the value at each node is the same as the value of a option-free bond. But, when the put option is exercised, the value at which the put is exercised, i.e., 98 is used for further calculation instead of the value obtained from backward induction. The value produced by this process is higher than the value of the option-free bond because:
Value of the putable bond = Value of the non-putable bond + Value of the put option.
We can rewrite it as follows:
Value of the put option = Value of the non-putable bond - Value of the putable bond
From the illustration, we can determine the value of the put option as follows:
Value of the put option = Rs.100.714 - Rs.101.799 = Rs.-1.065 (the negative sign implies that the issuer has sold the option and the investor has purchased the option.)
Table 1: Valuing a Putable Bond