Bonds With Embedded Options - Valuation and Analysis

VALUATION AND ANALYSIS: BONDS
WITH EMBEDDED OPTIONS

Reference: Chapter 9 (PET) + Other Notes (FAB)
Presented By:
M. EMRUL HASAN, CFA, FRM, PhD
Visiting Lecturer, Beedie School of
Business, Simon Fraser University
Lecturer, Vancouver School of
Economics, UBC
Director of Learning, FinanceTraining.ca
Copyright: CFA Institute and FinanceTraining.ca
08/10/2021 1
1. INTRODUCTION
• The valuation of a fixed-rate option-free bond generally
requires determining its future cash flows and discounting
them at the appropriate rates.
• Valuation becomes more complicated when a bond has
one or more embedded options because the values of
embedded options are typically contingent on interest
rates.
• Issuers and investors should understand how embedded
options — such as call and put provisions, conversion
options, caps, and floors — affect bond values and the
sensitivity of these bonds to interest rate movements.

08/10/2021 2
2. OVERVIEW OF EMBEDDED OPTIONS
The term These options are

These options
embedded options not independent of
represent rights that
refers to the bond and thus
enable their holders
contingency cannot be traded
to take advantage of
provisions found in separately — hence
interest rate
the bond’s indenture the adjective
movements.
or offering circular. “embedded.”

08/10/2021 3
CALL OPTIONS
• A callable bond is a bond that includes an embedded call
option.
• The call provision allows the issuer to redeem the bond
issue prior to maturity.
• Early redemption usually happens when the issuer has the
opportunity to replace a high-coupon bond with another bond
that has more favorable terms.
• Most callable bonds include a lockout period during which the
issuer cannot call the bond.
• Callable bonds include different types of call features:

European, American, or Bermudan style.

08/10/2021 4
CALLABLE BONDS AND THEIR INVESTMENT
CHARACTERISTICS (FABOZZI)
• The presence of a call option results in two
disadvantages to the bondholder:
• callable bonds expose bondholders to
reinvestment risk
• price appreciation potential for a callable bond in
a declining interest-rate environment is limited
• This phenomenon for a callable bond is referred to
as price compression.
• If the investor receives sufficient potential
compensation in the form of a higher potential
yield, an investor would be willing to accept the
call risk.
Copyright © 2016 Pearson Education, Inc. 18-5
• Traditional Valuation Methodology for Callable Bonds
o When a bond is callable, the practice has been to calculate a
yield to worst, which is the smallest of the yield to maturity
and the yield to call for all possible call dates.
o The yield to call (like the yield to maturity) assumes that all
cash flows can be reinvested at the computed yield—in this
case the yield to call—until the assumed call date.
o Moreover, the yield to call assumes that
1) the investor will hold the bond to the assumed call date
2) the issuer will call the bond on that date.
o Often, these underlying assumptions about the yield to call
are unrealistic because they do not take into account how
an investor will reinvest the proceeds if the issue is called.

• Price-Yield Relationship for a Callable Bond
o The price–yield relationship for an option-free bond is convex.
o If a callable bond is unlikely to be called, it will have the same convex
price–yield relationship as a noncallable bond when yields are greater
than y* (next slide).
o As yields in the market decline, the likelihood that yields will decline
further so that the issuer will benefit from calling the bond increases.
o The exact yield level at which investors begin to view the issue likely to
be called may not be known, but we do know that there is some level,
say y*.
o For a range of yields below y*, there is price compression–that is, there
is limited price appreciation as yields decline.
o The portion of the callable bond price-yield relationship below y* is said
to be negatively convex which means that the price appreciation will be
less than the price depreciation for a large change in yield of a given
number of basis points.
o It is important to understand that a bond can still trade above it’s call price
even if it is highly likely to be called.
PRICE-YIELD RELATIONSHIP FOR A
NONCALLABLE AND CALLABLE BOND (FABOZZI)
Price
a’
Noncallable Bond
a’- a
b
Callable
Bond
a-b a
y* Yield
COMPONENTS OF A BOND WITH AN
EMBEDDED OPTION (FABOZZI)
• A callable bond is a bond in which the bondholder has sold the issuer a call
option that allows the issuer to repurchase the contractual cash flows of the
bond from the time the bond is first callable until the maturity date.
• The owner of a callable bond is entering into two separate transactions:
• buys a noncallable bond from the issuer for which she pays some price
• sells the issuer a call option for which she receives the option price
• A callable bond is equal to the price of the two components parts; that is,
• callable bond price = noncallable bond price – call option price
• The call option price is subtracted from the price of the noncallable bond
because when the bondholder sells a call option, she receives the option
price.
• The difference between the price of the noncallable bond and the callable
bond at any given yield is the price of the embedded call option.

DECOMPOSITION OF A PRICE OF A CALLABLE
BOND (FABOZZI)
Note: At y** yield level: PNCB = noncallable bond price
PCB = callable bond price
Price PNCB - PCB = call option price
a’
PNCB
Noncallable Bond
PCB a’- a
b
Callable
Bond
a
a-b
y** y* Yield
PUT OPTIONS AND EXTENSION OPTIONS
• A putable bond is a bond that includes an embedded put
option.
• The put provision allows the bondholders to put back the
bonds to the issuer prior to maturity, usually at par.
• Similar to callable bonds, most putable bonds include lockout
periods.
• They can be European or, rarely, Bermudan style, but there are
no American-style putable bonds.
• An embedded option that resembles a put option is an

extension option — the right to keep the bond for a number of
years after maturity, possibly with a different coupon.

08/10/2021 11
COMPONENTS OF A BOND WITH AN
EMBEDDED OPTION (FABOZZI)
• The logic applied to callable bonds can be similarly applied
to putable bonds.
• In the case of a putable bond, the bondholder has the right
to sell the bond to the issuer at a designated price and time.
• A putable bond can be broken into two separate
transactions.
• The investor buys a noncallable bond.
• The investor buys an option from the issuer that allows the
investor to sell the bond to the issuer.
• The price of a putable bond is then
putable bond price = non-putable bond price + put option
price

COMPLEX EMBEDDED OPTIONS
• Although callable and putable bonds are the most common
types of bonds with embedded options, there are bonds
with other types of options or combinations of options.
A bond can be both callable and putable.
A bond can be convertible (to stock).
A bond may have an option that is contingent on some

particular event.
A bond may contain interrelated issuer options without any investor

option, such as a sinking fund bond. A “sinker” may also include an
acceleration provision or a delivery option.

08/10/2021 13
3. VALUATION AND ANALYSIS OF
CALLABLE AND PUTABLE BONDS
The value of a bond with embedded options is equal to the
sum of the arbitrage-free value of the straight bond and the
arbitrage-free values of the embedded options.
Value of callable bond = Value of straight bond – Value of issuer call option
Value of issuer call option = Value of straight bond – Value of callable bond
Value of putable bond = Value of straight bond + Value of investor put option
Value of investor put option = Value of putable bond – Value of straight bond

08/10/2021 14
VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS
Refresher:
• The approach relying on one-period forward rates provides an
appropriate framework for valuing bonds with embedded
options.
We need to know the value of the bond at different points in
time in the future to determine whether the embedded option
will be exercised at those points in time.
Example: Consider the valuation of a three-year 4.25% annual

coupon bond 1) callable at par; 2) putable at par (1 and 2 years
from now); and 3) equivalent non-callable bond at zero volatility.
Forward rates are presented in the following table.

08/10/2021 15
Example (continued).
Today 1 Year 2 Year 3 Year
Cash
Cash Flow
Flow 4.250
4.250 4.250
4.250 104.250
104.250
Discount Rate 2.500% 3.518% 4.564%
Discount Rate 2.500% 3.518% 4.564%
Value of the =101.707 =100.417 =99.7
Value of Bond
Callable the
Called at 100 Not called
Callable Bond
Value of the =102.397 =100.707 =99.7
Value
PutableofBond
the Not put Put at 100
Putable Bond
Value of =102.114 =100.417 =99.7
Option-Free
Value of
Bond
Option-Free
Bond
08/10/2021 16
In the exercise shown on the previous slide, the values of

respective call and put options are:
Value of issuer call option = 102.114 – 101.707 = $0.407
Value of investor put option = 102.397 – 102.114 = $0.283

08/10/2021 17
INTEREST RATE VOLATILITY
• The value of any embedded option, regardless of the type
of option, increases with interest rate volatility.
• The greater the volatility, the more opportunities exist for
the embedded option to be exercised.
All else being equal, the call option

increases in value with interest rate
volatility. Thus, as interest rate volatility
increases, the value of the callable bond
decreases.
All else being equal, the put option
increases in value with interest rate
volatility. Thus, as interest rate volatility
increases, the value of the putable bond
increases.

08/10/2021 18
YIELD CURVE EFFECTS
• The value of a callable or putable bond is also affected by
changes in the level and shape of the yield curve.
• For a callable bond:
If the yield curve shifts down, the
value of the callable bond rises less
rapidly than the value of the straight
bond, limiting the upside potential
for the investor (level effect).
All else being equal, the value of

the call option increases as the
yield curve flattens or inverts (effect
of the shape).

08/10/2021 19
YIELD CURVE EFFECTS
• For a putable bond:
If the yield curve shifts up, the
value of the putable bond falls
slower than the value of the
straight bond, limiting the
downside loss for the investor
(level effect).
All else being equal, the value of

the put option decreases as the
yield curve flattens or inverts
(effect of the shape).

08/10/2021 20
VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
• The procedure to value a bond with an embedded option in the
presence of interest rate volatility is as follows:
Generate a tree of interest
rates based on the given
yield curve and interest rate
volatility assumptions.
At each node of the tree,
determine whether the embedded
options will be exercised.
Apply the backward induction valuation
methodology to calculate the bond’s
present value.
This methodology involves starting at
maturity and working back from right to
left to find the bond’s present value.
08/10/2021 21
Example. Consider a default-free three-year 4.25% annual
coupon bond using the interest rate tree below (10% volatility) if in
years 1 and 2 they are 1) callable and 2) putable at par:
5.5258%
3.8695%
2.5% 4.5245%
3.1681%
3.7041%
Year 0 Year 1 Year 2

08/10/2021 22
1) Callable bond C=4.25
5.5258%
V=100
3.3695% C=4.25
C=4.25 V=98.791
2.5% 5.5258% C=4.25
V=99.658
4.5242% V=100
V=101.540 3.3695% C=4.25
3.1681% V=99.738
2.5% C=4.25 4.5242% C=4.25
V=100.922 3.7041% V=100
Called at 100
3.1681% C=4.25
V=100.526 C=4.25
Called at 100 3.7041% V=100
Year 0 Year 1 Year 2 Year 3
[where C = cash flow (% of par) and V = value of the callable bond’s future cash flows (% of par).]
08/10/2021 23
C=4.25
2) Putable bond 5.5258%
V=100
3.3695% C=4.25
C=4.25 V=98.791
2.5% Put at 100 5.5258% C=4.25
V=100.366
4.5242% V=100
V=102.522 3.3695% C=4.25
3.1681% V=99.738
2.5% C=4.25 Put at 100 4.5242% C=4.25
V=101.304 3.7041% V=100
3.1681% C=4.25
V=100.526 C=4.25
3.7041% V=100

08/10/2021 24
VALUATION MODEL (FABOZZI))
• Impact of Expected Interest-Rate Volatility on
Price
o Expected interest-rate volatility is a key input into the valuation
of bonds with embedded options. We observe the following
from next slide:
1) The price of the option-free bond is the same regardless of
the interest-rate volatility assumed. This is expected since
there is no embedded option that is affected by interest-rate
volatility.
2) For any given level of interest-rate volatility, the longer the
deferred call, the higher the price. Again, as expected the
value of the option-free bond has the highest price.
3) The price of a callable bond moves inversely to the interest-
rate volatility assumed.

EFFECT OF INTEREST-RATE VOLATILITY AND YEARS TO CALL ON
PRICES OF 5%, 10-YEAR CALLABLE BONDS (FABOZZI)
(NOTE: PRICES CALCULATED USING ANDREW KALOTAY ASSOCIATES BONDOAS™ USING 3,000 INTEREST-RATE LATTICES)
109
Price (%)
107
105
103
101
99
97
12 14 16 18 20 22 24 26 28 30
Volatility of Short-Term Interest Rate (%)

VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
The approach for default-free (sovereign) bonds can be
extended to risky (corporate) bonds.
The industry-standard approach

is to increase the discount rates
above the default-free rates to
reflect default risk.
The second approach to valuing

risky bonds is by making the
default probabilities explicit —
that is, by assigning a probability
to each time period going
forward.
08/10/2021 27
AND PUTABLE BONDS (FABOZZI)
• Incorporating Default Risk
o The basic binomial model explained above can be extended to incorporate
default risk.
o The extension involves adjusting the expected cash flows for the probability
of a payment default and the expected amount of cash that will be
recovered when a default occurs.
• Modeling Risk
o The user of any valuation model is exposed to modeling risk.
o This is the risk that the output of the model is incorrect because the
assumptions upon which it is based are incorrect.
• Implementation Challenge
o To transform the basic interest-rate tree into a practical tool requires
refinements.
• For example, the spacing of the node lines in the tree must be much finer.
• Although one can introduce time-dependent node spacing, caution is
required; it is easy to distort the term structure of volatility.
• Other practical difficulties include the management of cash flows that fall
between two node lines.
AND PUTABLE BONDS
• Use an issuer-specific curve (might be

There are two impossible due to cost and availability
standard approaches of data).
to construct a suitable • Raise the one-year forward rates
yield curve for a risky
bond: derived from the default-free benchmark
yield curve by a fixed Z-spread.
A second approach can be used for risky bonds with

embedded options:
• Option-adjusted spread (OAS) is the constant spread
that, when added to all the one-period forward rates on
the interest rate tree, makes the arbitrage-free value of
the bond equal to its market price.
08/10/2021 29
OPTION-ADJUSTED SPREAD (FABOZZI)
• The option-adjusted spread (OAS) was
developed as a measure of the yield spread (in
basis points) that can be used to convert dollar
differences between value and price.
• Thus, basically, the OAS is used to reconcile
value with market price.
• The OAS is a spread over the spot rate curve
or benchmark used in the valuation.
• The reason that the resulting spread is referred
to as option-adjusted is because the cash flows
of the security whose value we seek are
adjusted to reflect the embedded option.
OPTION-ADJUSTED SPREAD (FABOZZI)
• Translating OAS to Theoretical Value
o Although the product of a valuation model is the OAS,
the process can be worked in reverse.
o For a specified OAS, the valuation model can
determine the theoretical value of the security that is
consistent with that OAS.
o As with the theoretical value, the OAS is affected by
the assumed interest-rate volatility.
o The higher (lower) the expected interest-rate volatility,
the lower (higher) the OAS.
• Determining the Option Value in Spread Terms
o The option value in spread terms is determined as
follows:
option value (in basis points) = static spread – OAS

OPTION-ADJUSTED SPREAD
The dispersion of interest rates on the tree is volatility

dependent, and so is the OAS.
As interest rate
volatility
increases,
the OAS for the

callable bond
decreases.

08/10/2021 32
4. INTEREST RATE RISK OF BONDS WITH
EMBEDDED OPTIONS
•• The duration of a bond measures the sensitivity of the
bond’s full price to changes in the bond’s yield to maturity
or to changes in benchmark interest rates.
• For bonds with embedded options, the only appropriate
duration measure is the curve duration measure known as
effective (or option-adjusted) duration.
Effective duration indicates the sensitivity of the bond’s price to
a 100 bps parallel shift of the benchmark yield curve assuming
no change in the bond’s credit spread.

08/10/2021 33
CALCULATING A BOND’S EFFECTIVE DURATION
IN PRACTICE
In practice, the estimation procedure is usually as follows:
Shift the
Shift the
benchmark
benchmark
Given a yield curve
yield curve up
price (PV0), down,
by the same
calculate generate a
magnitude,
the implied new
generate a Calculate
OAS to the interest
new interest the
benchmark rate tree,
rate tree, and bond’s
yield curve and then
then revalue effective
at an revalue the
the bond duration.
appropriate bond using
using the
interest the OAS
OAS
rate calculated
calculated in
volatility in Step 1.
Step 1. This
This value
value is PV+.
is PV–.
08/10/2021 34
INTEREST RATE RISK OF BONDS WITH
EMBEDDED OPTIONS
The effective duration of a callable bond cannot exceed that of the
straight bond.
When interest rates are high relative to the bond’s
coupon, the callable and straight bonds have similar
effective durations.
When interest rates fall, the effective duration of the
callable bond is lower than that of the straight bond.
The effective duration of a putable bond cannot exceed that of the

straight bond.
When interest rates are low relative to the bond’s
coupon, the putable and straight bonds have similar
effective durations.
When interest rates rise, the effective duration of the
putable bond is lower than that of the straight bond.
08/10/2021 35
ONE-SIDED DURATION
AND KEY RATE DURATION
One-sided duration • It is better at capturing the interest rate

is an effective sensitivity of a callable or putable bond
duration when than the (two-sided) effective duration,
interest rates go up particularly when the embedded option is
or down. near the money.
Key rate duration

reflects the • Key rate durations help portfolio managers
sensitivity of the and risk managers identify the “shaping
bond’s price to risk” for bonds — that is, the bond’s
changes in specific sensitivity to changes in the shape of the
maturities on the yield curve (e.g., steepening and
benchmark yield flattening).
curve.
08/10/2021 36
EFFECTIVE CONVEXITY
Effective convexity is calculated for callable, putable bonds
similar to the straight bond.
• When interest rates are high, the callable and straight bond
experience very similar positive convexity.
• The effective convexity of the callable bond turns negative

when the call option is near the money.
• Putable bonds always have positive convexity. It is similar

to the straight bond when interest rates are low.
• When the put option is near the money, the convexity of a

putable bond becomes larger than that of a straight bond.

08/10/2021 37
5. VALUATION AND ANALYSIS OF CAPPED AND
FLOORED FLOATING-RATE BONDS
• Capped and floored floaters can be valued by using the arbitrage-free
framework.
• A capped floater protects the issuer against rising interest rates and is
thus an issuer option.
• The investor is long in the bond but short in the embedded option.
Value of Value of Value of

capped straight embedded
floater bond cap
Example: Consider a three-year LIBOR floater capped at 4.5% at 10%

interest rate volatility. The interest rate tree is the same as in earlier
examples.
08/10/2021 38
VALUATION OF A CAPPED FLOATER
C=5.5258 4.5
Capped Floater: 5.5258% V=100
3.3695% C=3.8695 C=5.5258 4.5
C=2.5 V=99.028 V=100
2.5% 5.5258%
V=99.521
CH=3.3695 4.5242% C=4.5242 4.5
V=99.761 3.3695% V=100
3.1681% V=99.977
C=4.5242 4.5
2.5% C=2.5 CL=3.1681 4.5242% V=100
V=99.989 3.7041%
C=3.7041
3.1681% C=3.1681 V=100
V=100.000
3.7041% C=3.7041
V=100
Value of embedded cap = 100 – 99.761 = 0.239.

08/10/2021 39
VALUATION OF A FLOORED FLOATER
• The floor provision in a floater prevents the coupon rate from
decreasing below a specified minimum rate.
• A floored floater protects the investor against declining interest
rates and is thus an investor option.
• The investor is long both in the bond and in the embedded option.

floored straight embedded
floater bond floor
Example: Consider a three-year LIBOR floater floored at 3.5% at 10%

interest rate volatility. The interest rate tree is the same as in earlier
examples.
08/10/2021 40
VALUATION OF A FLOORED FLOATER
C = 5.5258
Floored Floater: 5.5258% V = 100
3.3695% C = 3.8695 C = 5.5258
C = 2.500 V = 100 V = 100
2.5% 5.5258%
3.500
CH = 3.8695 4.5242% C = 4.5242
V = 100
V = 101.133 3.3695% V = 100
3.1681% V = 100
C = 4.5242
2.5% C = 2.500 CL = 3.1681 4.5242% V = 100
3.500 3.7041%
3.500
V = 100.322 C = 3.7041
3.1681% C = 3.1681 V = 100
3.500
V = 100 3.7041% C = 3.7041
V = 100
Value of embedded floor = 101.133 – 100 = 1.133.
08/10/2021 41
6. VALUATION AND ANALYSIS OF
CONVERTIBLE BONDS
A convertible bond is a hybrid security that presents the
characteristics of an option-free bond and an embedded
conversion option.
The conversion option is a call

option on the issuer’s common
The number of shares of common
stock, which gives bondholders the
stock that the bondholder receives
right to convert their debt into equity
from converting the bonds into
during a pre-determined period
shares is called the “conversion
(known as the conversion period)
ratio.”
at a pre-determined price (known as
the conversion price).

08/10/2021 42
CONVERTIBLE BOND PROVISIONS (FABOZZI)
• Along with the conversion privilege granted to the
bondholder, most convertible bonds are callable at the
option of the issuer as of a certain date.
 This standard type of call option in a convertible bond is called
an unprotected call.
 There is another type of call feature that is included in some
convertible bond issues:
- The bond may only be called if the price of the underlying
stock (or the average stock price over some number of days)
exceeds a specified trigger price. This type of call is known
as a protected call.

• Some convertible bonds are putable.
 Put options can be classified as hard puts and soft puts.
• A hard put is one in which the convertible security must
be redeemed by the issuer only for cash.
• In the case of a soft put, the issuer has the option to
redeem the convertible security for cash, common stock,
subordinated notes, or a combination of the three.
• Another convertible that was at one time issued for
its favorable tax treatment is one with a contingent
payment provision, nicknamed “CoPa” bonds.
 Unlike a traditional convertible bond whose coupon rate is
fixed over the bond’s life, a CoPa bond pays a higher
coupon rate if the price of the underlying stock prices
reaches a specified threshold (say, 125% of the
conversion price).
• Special Conversion Provisions
 An investor must look carefully at the conversion privilege because not
all bonds allow a straightforward conversion privilege.
 Two types of convertible bonds issued prior to 2008 that departed from
the traditional conversion privilege are the net share settlement
convertible and the contingent conversion convertible.
1) For a convertible bond that includes a net share settlement
provision, upon exercise of the conversion option to convert, the
issuer pays the par value in cash to retire the bonds but the bond will
be trading above its par value. Issuer motivation for the issuance of
convertible bonds with this provision (also called cash-par settlement
provision) was that from a financial accounting perspective,
convertible bonds with net share settlement provisions were treated
favorably in the calculation of the issuer’s earnings per share.
2) With a contingent convertible provision, the holder only has the
right to convert when the price of the underlying stock exceeds a
specified threshold price for a specified number of trading days.

THE DIFFERENT SUBINDEXES OF THE FOUR INDICES SHOWN
BELOW INDICATE THE DIFFERENT SUBSECTORS OR WAYS TO
CATEGORIZE THE CONVERTIBLE BOND MARKET. (FABOZZI)
Type Credit Quality

• Cash-pay bonds •Investment grade
• Zero-coupon/original •Intermediate grade
issue discount •Junk
• Preferreds •Nonrated
• Mandatories
Underlying Market Profile
Capitalization •Typical
• Small cap •Equity sensitive
• Mid cap •Busted
• Large cap •Distressed

CATEGORIZATION OF CONVERTIBLE
SECURITIES (FABOZZI)
• With respect to “Type” of convertible security, cash-pay bonds,
also referred to as traditional convertible bonds, are a convertible
bonds that pay coupon interest.
• Zero-coupon convertible bonds are like any other bonds that pay
no coupon interest.
• A popular type of zero-coupon bond is a Merrill Lynch product
called LYON, which stands for Liquid Yield Option Notes.
• An original issue discount (OID) convertible bond is issued at a
discount from par but has some coupon interest: the coupon
interest rate is a below market rate.
• A convertible preferred is a preferred stock that can be converted
into common stock.
• Finally, mandatory convertible is a convertible security that
converts automatically at maturity into shares of the issuer’s
common stock. This automatic conversion differs from convertible
bonds where conversion is optional.

CONVERSION VALUE
• The conversion value or parity value of a convertible
bond indicates the value of the bond if it is converted at the
market price of the shares.
Conversion Underlying Conversion

value share price ratio
The minimum value of a convertible bond is equal to the

greater of the following:
Value of the
Conversion value and underlying option-
free bond
08/10/2021 48
MARKET CONVERSION PRICE AND PREMIUM
•• Themarket conversion premium per share allows investors to
identify the premium or discount payable when buying the
convertible bond rather than the underlying common stock.
Market conversion premium per share = Market conversion price –
Underlying share price
The market conversion premium ratio expresses the premium

or discount investors have to pay as a percentage of the current
market price of the shares:

08/10/2021 49
CURRENT INCOME OF CONVERTIBLE BOND
VERSUS STOCK (FABOZZI)
• As an offset to the market conversion premium per

share, investing in the convertible bond rather than
buying the stock directly generally means that the
investor realizes higher current income from the
coupon interest paid on the convertible bond than
would be received as dividends paid on the number
of shares equal to the conversion ratio.
• Analysts evaluating a convertible bond typically
compute the time it takes to recover the premium per
share by computing the premium payback period
(which is also known as the break-even time).

• The premium payback period (which is also known as the
break-even time) is computed as follows:
market conversion premium per share
premium payback period 
favorable income differential per share
where the favorable income differential per share is equal to
 coupon rate  par value    conversion ratio  dividend per share 
conversion ratio
where the coupon interest = coupon rate × par value and the
premium payback period does not take into account the
time value of money.

• Illustration. For the XYZ convertible bond where the coupon
rate is 10%, the conversion ratio is 50, the dividend per share is
$1, and the market conversion premium per share is $2, how long
would it take an investor to recover the market conversion
premium per share?
 We first compute the favorable income differential per share, which
is found by first computing the coupon interest from the bond.
 We have: coupon interest from bond = (coupon rate)(par value) =
0.10($1,000) = $100.
 The favorable income differential per share is:
 coupon rate  par value    conversion ratio  dividend per share 
conversion ratio
$100   50  $1 
  $1.00
50
• Illustration (continued)
 The premium payback period can now be
computed. We have:
premium payback period 
market conversion premium per share $2
  2 years
favorable income differential per share $1
 Thus, without considering the time value of money, the
investor would recover the market conversion premium
per share in two years.

DOWNSIDE RISK AND UPSIDE POTENTIAL
OF CONVERTIBLE BONDS
••
Many investors use the straight value as a measure of
the downside risk of a convertible bond and calculate
the following metric:
• The upside potential of a convertible bond depends

primarily on the prospects of the underlying common
stock.
Thus, convertible bond investors should be familiar with the

techniques used to value and analyze common stocks.

08/10/2021 54
DOWNSIDE RISK WITH A
CONVERTIBLE BOND (FABOZZI)
• Illustration. Earlier, we said that if comparable nonconvertible
bonds are trading to yield 14%, the straight value of the XYZ
bond would be $788. What is the premium over straight value for
bond XYZ if the convertible bond has a market price of $950?
premium over straight value 
 market price of the convertible bond

straight value
 1 = 
$950
 1  1.2055838 – 1  0.2055838 or about 21%
$788
• If the yield on a comparable nonconvertible bond is 11.8%
instead of 14%, the straight value would be $896. What would
the premium over straight value be?
premium over straight value = ($950 / $896) – 1 = 0.06 or 6%
VALUATION OF A CONVERTIBLE BOND
The most commonly used model to value convertible bonds
is the arbitrage-free framework.
Value of convertible
= stock
Value of straight
Value of call option
on the issuer’s
bond bond
stock
Value of Value of call Value of

Value of callable
straight option on the issuer call
convertible bond
bond issuer’s stock option
Value of
Value of call option
callable putable issuer investor
straight on the
convertible call put
bond issuer’s
bond option option
stock

08/10/2021 56
OPTIONS APPROACH TO VALUATION (FABOZZI)
• An investor who purchases a noncallable/nonputable convertible
bond would be entering into two separate transactions:
1) buying a noncallable/nonputable straight bond
2) buying a call option on the stock, where the number of shares that can
be purchased with the call option is equal to the conversion ratio
• The fair value for the call option depends on the factors that affect
the price of a call option.
 One key factor is the expected price volatility of the stock: the more
the expected price volatility, the greater the value of the call option.
 As a first approximation to the value of a convertible bond, the
formula would be
convertible bond value = straight value + price of the call option on the
stock
 The price of the call option is added to the straight value because
the investor has purchased a call option on the stock.

OPTIONS APPROACH TO VALUATION (FABOZZI)
• Consider a common feature of a convertible bond: the issuer’s right
to call the bond.
 If called, the investor can lose any premium over the conversion
value that is reflected in the market price.
 Therefore, the analysis of convertible bonds must take into
account the value of the issuer’s right to call the bond.
 This depends, in turn, future interest rate volatility, and economic
factors that determine whether it is optimal for the issuer to call
the bond.
• The Black-Scholes option pricing model cannot handle this situation.
 Instead, the binomial option pricing model can be used
simultaneously to value the bondholder’s call option on the stock
and the issuer’s right to call the bonds.
 The bondholder’s put option can also be accommodated.
 To link interest rates and stock prices together, statistical
analysis of historical movements of these two variables must be
estimated and incorporated into the model.

RISK–RETURN CHARACERISTICS OF A CONVERTIBLE
BOND, A STRAIGHT BOND, AND THE UNDERLYING STOCK
.
When the underlying In contrast, when
share price is well the underlying
below the conversion share price is above
price, the convertible the conversion
bond is described as price, a convertible
“busted convertible” bond exhibits
and exhibits mostly mostly stock risk–
bond risk–return return
characteristics. characteristics.
.
In between the bond and the stock extremes, the convertible

bond trades like a hybrid instrument.
08/10/2021 59
OPTION MEASURES (FABOZZI)
• Because a convertible bond embeds a call option on the underlying
common stock, we can estimate the sensitivity of a convertible bond’s
price from measures used in option theory.
• The measures we describe are delta, gamma, vega, and implied
volatility.
• Basically, these measures relate to the factors that affect the value of
an option.
• The first three measures show the sensitivity of the option’s price to
changes in a particular factor that is known to affect the price.
• Several of these factors, in the case of an option on a stock, include:
the price of the underlying stock; the expected volatility of the
underlying stock’s price; and, the amount of time remaining to the
expiration of the option.
• The measures are calculated by using a theoretical model to value the
price of an option (the most common for options on common stock is
the well-known Black–Scholes option pricing model) and determining
how the theoretical value changes when a factor (holding all other
factors constant) changes.
Delta
 An option’s delta measures the sensitivity of an option’s
price to a change in the price of the underlying.
 For an option on common stock, the underlying is
common stock.
 In the case of a convertible bond, the underlying is the
common stock of the issuer.
 Hence, a convertible bond’s delta is the sensitivity of its
value to a change in the underlying stock’s price.
 Another name used for delta is hedge ratio or neutral
hedge ratio.
 More specifically, delta is the ratio of the change in the
convertible’s value to the change in the price of the
underlying shares.

Delta
 The delta is used to estimate the impact of a change in
the price per share of the underlying stock on the
convertible bond’s value as follows:
approximate change in a convertible bond’s value =
change in stock price per share × conversion ratio × delta
 EXAMPLE. Consider convertible bond, bond XYZ
described earlier with a conversion ratio of 50. Suppose
that the delta is 0.60. For a price change of $0.125 for
the stock price per share, what is the approximate
change in the convertible bond’s value?
approximate change in a convertible bond’s value =
change in stock price per share × conversion ratio × delta
= $0.125 × 50 × 0.60 = $3.75

Delta
• Multiplying the delta by the conversion ratio of 50 gives 30.
 This means that 30 shares must be shorted in order to obtain a market
neutral position.
 For example, suppose the price of the underlying shares increases by
$0.125. This means the short position consisting of 30 shares of stock
will lose $0.128 × $30 = $3.75.
There are two important points to know about delta.

1) First, delta is only an approximation of the change in the value of a
convertible bond for a small change in the price of the stock.
2) Second, an option’s delta changes over time.
• It changes due to a change in the price of the underlying stock and
changes in the other factors that are known to affect the value of an
option such as the amount of time remaining until the option expires.
• So, if an investor wanted to maintain a hedged position (i.e., market
neutral position) in the convertible bond and short stock position, the
short position would have to be changed as delta changes.

Gamma
 Duration is the first approximation of how the bond’s
price will change when interest rates change.
 The convexity measure shows for larger change in
interest rates what the additional change in the bond’s
price will be.
 Basically, convexity relates to the benefit associated
with larger interest rate movements or interest rate
volatility.
 In option theory, gamma plays the same role as
convexity.
 In the case of a convertible bond, gamma is the
additional change in the convertible bond’s value for a
larger change in the price of the underlying stock.
Vega
 An option’s vega is the sensitivity of the
option’s price to a change in expected
volatility for the underlying.
 For a convertible bond, it is an estimate of
the sensitivity of the convertible bond’s
price to a change in the expected volatility
of the stock’s price.

Implied Volatility
 In an option pricing model, the only unknown input
that must be estimated is expected volatility.
 A common practice in the option market is to “back
out” what the expected volatility is given the
observed market price for the option and the option
pricing model.
 The volatility so obtained is referred to as implied
volatility.
 The difference between implied volatility and
historical volatility often is the basis for trading
strategies in the options market and is also used for
that purpose in the convertible bond market.

PROFILE OF A CONVERTIBLE BOND (FABOZZI)
• In describing how to categorize convertible
securities at the outset of this chapter, one way to
categorize is by the convertible’s profile.
• Basically, by profile we mean the factors that
dominate the performance of the convertible such
as the stock price of the issuer or the level of
interest rates and spreads.
• Some categories are -
• typical
• equity sensitive
• busted
• distressed

PROFILE OF A CONVERTIBLE BOND (FABOZZI)
• By a “typical” convertible, it can refer to a balanced
convertible with hedge ratios, or equivalently, their correlation
with stock price changes, ranging from roughly 55% to 80%.
• An equity sensitive convertible, also referred to as an equity
substitute convertible by practitioners, is one in which the
underlying stock price exceeds the conversion price of the
stock.
• When the price of the underlying stock is very far below the
conversion price, the convertible is said to be a busted
convertible.
• A distressed convertible can be viewed as a special type of
busted convertible where the price of the underlying stock
has fallen so far below the conversion price that it is likely
that the issuer will be forced into bankruptcy.

PROS AND CONS OF INVESTING IN A
• One disadvantage of buying the bond is that the
conversion price is higher than the price at the
time the convertible bond is purchased. Thus, the
return will be lower unless the interest payments
for the length of ownership of the convertible bond
are great enough to cover
• the higher price paid per share
• any dividends that are forgone for the length of time
• An advantage of buying the bond is that its value
will likely fall less than that of stock if a firm runs
into financial distress difficulties.

PROS AND CONS OF INVESTING IN A
Call Risk
 Convertible issues are callable by the issuer.
 This is a valuable feature for issuers, who deem the current
market price of their stock undervalued enough so that selling
stock directly would dilute the equity of current stockholders.
 The firm would prefer to raise equity funds over incurring debt,
so it issues a convertible, setting the conversion ratio on the
basis of a stock price it regards as acceptable.
Takeover Risk
 Corporate takeovers represent another risk to investing in
convertible bonds.
 As the stock of the acquired company may no longer trade
after a takeover, the investor can be left with a bond that pays a
lower coupon rate than comparable-risk corporate bonds.

CONVERTIBLE BOND ARBITRAGE (FABOZZI)
• Because of the investment characteristics of convertible bonds
that we have described in this chapter, their payoff characteristics
allow the creation of different positions that can benefit from the
mispricing of a convertible bond.
• Seeking to capitalize on the perceived mispricing of a convertible
bond issue is referred to as convertible bond arbitrage.
• The first step in all convertible bond arbitrage strategies is to
identify convertible bonds that are trading at a price that
substantially deviates from the theoretical value indicated by the
manager’s convertible bond model.
• Hence, the process is heavily dependent on this valuation model.
• For those convertible bonds that are identified as substantially
misvalued in the market, a position is taken in the convertible
bond, the underlying common stock, and derivative instrument
needed to hedge market risks that could otherwise adversely
impact the objective of the convertible bond arbitrage strategies.

Attributes of Issues for Use in a Convertible
Bond Arbitrage Strategy
 In screening the candidate list of convertible bond issues
for a convertible bond arbitrage strategy, the manager
will prefer those with certain attributes for the underlying
common stock and for the convertible bond issue itself.
 For the convertible bond itself, the following attributes
are desirable in a convertible bond arbitrage: good
liquidity, low conversion premium, high convexity, and
low implied volatility.
 With respect to the underlying common stock, the
following attributes are desirable: high expected price
volatility, can be easily borrowed, and pay little or no
dividends.

Types of Strategy
 The idea behind a cash flow arbitrage strategy is to create
equivalent positions in the convertible bond and underlying
stock so that any additional cash flow available from the
convertible bond can be captured while eliminating or
mitigating any risks.
 In convertible bond arbitrage trades, typically a long position
is established in the convertible bond, and simultaneously, a
short position is established in the underlying stock.
 The objective in a volatility trading strategy is that regardless
of how the price of the underlying stock price changes, the
mispriced convertible bond’s value will outperform the value
of the short position in the underlying stock’s value.

Types of Strategy
 As with most option trading strategies, the position
of a strategy must be changed as the price of the
underlying changes.
 There are option strategies that involve capitalizing
on the expected change in the delta of an option.
 In a convertible bond arbitrage gamma trading
strategy, instead of adjusting the short position in
the underlying stock as specified by the delta, the
manager takes a position based on the expected
change in the delta.
 The expectation is to generate additional income
when the stock price changes.

7. BOND ANALYTICS
• Some market participants, in particular financial institutions,
develop bond analysis system in-house.
• How can a practitioner tell if such a system is adequate?
- The system should be able to report the correct cash flows, discount
rates, and present value of the cash flows. The discount rates can be
verified by hand or on a spreadsheet.
- Even if it is difficult to verify that a result is correct, it may be possible
to establish that it is wrong by doing the following checks:
Check that the put–call parity holds.
Check that the value of the underlying option-free bond does not
depend significantly on interest rate volatility.

08/10/2021 75

Bonds With Embedded Options - Valuation and Analysis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bonds With Embedded Options - Valuation and Analysis

Uploaded by

Copyright:

Available Formats

VALUATION AND ANALYSIS: BONDS

WITH EMBEDDED OPTIONS

Copyright: CFA Institute and FinanceTraining.ca

The term These options are

Copyright: CFA Institute and FinanceTraining.ca

• Callable bonds include different types of call features:

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

• An embedded option that resembles a put option is an

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

A bond can be convertible (to stock).

A bond may have an option that is contingent on some

A bond may contain interrelated issuer options without any investor

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Example: Consider the valuation of a three-year 4.25% annual

Copyright: CFA Institute and FinanceTraining.ca

In the exercise shown on the previous slide, the values of

Value of issuer call option = 102.114 – 101.707 = $0.407

Value of investor put option = 102.397 – 102.114 = $0.283

Copyright: CFA Institute and FinanceTraining.ca

All else being equal, the call option

Copyright: CFA Institute and FinanceTraining.ca

All else being equal, the value of

Copyright: CFA Institute and FinanceTraining.ca

All else being equal, the value of

Copyright: CFA Institute and FinanceTraining.ca

Year 0 Year 1 Year 2

Year 0 Year 1 Year 2 Year 3

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

The industry-standard approach

The second approach to valuing

• Use an issuer-specific curve (might be

A second approach can be used for risky bonds with

Copyright: CFA Institute and FinanceTraining.ca

The dispersion of interest rates on the tree is volatility

the OAS for the

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

The effective duration of a putable bond cannot exceed that of the

One-sided duration • It is better at capturing the interest rate

Key rate duration

• The effective convexity of the callable bond turns negative

• Putable bonds always have positive convexity. It is similar

• When the put option is near the money, the convexity of a

Copyright: CFA Institute and FinanceTraining.ca

Value of Value of Value of

Example: Consider a three-year LIBOR floater capped at 4.5% at 10%

Copyright: CFA Institute and FinanceTraining.ca

Value of Value of Value of

Example: Consider a three-year LIBOR floater floored at 3.5% at 10%

The conversion option is a call

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Type Credit Quality

Copyright: CFA Institute and FinanceTraining.ca

Copyright: CFA Institute and FinanceTraining.ca

Conversion Underlying Conversion