INTEREST RATE RISK

(Embedded Options in Debt)

INTEREST RATE RISK

Is the risk that arises for bond owners from fluctuating interest rates
 It depends on the sensitive of its price to interest rate changes in
the market(Bond’s time to maturity and the coupon rate of the
bond.
EMBEDDED OPTIONS IN DEBT/ CONTIGENCY PROVISIONS

 It is a clause in the legal document signed between issuer of the

bond and the investor, as per which either party is allowed to take
certain actions incase an event occurs eg. Market interest rate
goes down or share price of the company issuing bond goes up.
 Few of the most common bonds with embedded options are
callable bond, puttable bond and convertible bond.
CALLABLE BOND,PUTTABLE BOND AND CONVERTIBLE BOND

• Callable Bond- It gives issuer of the bond the right but not the obligation
to redeem all or certain part of the issued bond before the date of maturity at a
predetermined price thus being a call option.
• If market interest rate falls or credit rating improves; then the issuer of the bond will
replace old and costlier bond with new and cheaper bond .

• Puttable Bond- It gives the investor or holder of the bond a right but not an
obligation to sell the bond back to the issuer at a predetermined price on specific
dates thus being a put option.
• If the market interest rate goes up or credit rate decreases; then the investor will sell
low coupon rate bonds and buy bonds with high coupon rate.

• Convertible Bond- It gives the bondholder the right to exchange the

bond for a specified number of common shares in the issuing company.
• In case of price appreciation of the stock above the conversion rate an investor will
have an option to replace bond with specified number of shares and incase of stock
price below the conversion rate it has no impact on the investor’s interest payment.
 Scenario/Examples
• Callable Bond- For example, assuming that at the time of issuance of
the bond ; the market interest rate was 7% and that a company issued a bond
with a coupon rate of 8%. Now if market interest rate goes down to 4% then the
company can issue new bonds with coupon rate of 5%.

• Puttable Bond- For example, assuming that at the time of issuance of

the bond ; the market interest rate was 4% and that a company issued a bond
with a coupon rate of 5%. Now if market interest rate goes up to 7% then
company has to issue new bonds with coupon rate of 8%; thus puttable bonds
give opportunity to investor to sell the low coupon rate bonds and buy bonds
with higher coupon rate or higher discount.

• Convertible Bond- For example, the investor have an option to

replace the bond with specified number of shares if there will be a stock price
appreciation above the conversion rate & if stock price is below conversion rate
the investor can just get the money back when the bond matures since its not
wise to convert to shares.
ADVANTAGES DISADVANTAGES

Callable Bond
• Issuer of the bond can take advantage • Callable bonds are issued at deep
of the falling market interest rate as discount or higher coupon rate to
they can replace the old and costlier compensate the disadvantage of the
bond with new and cheaper bond. investor when interest rate fall.

Puttable Bond
• It gives the investor/bondholder a
chance to take advantage of increase in
the market interest rate.
• Puttabe bonds are issued at premium
or lower coupon rate to compensate
the disadvantage of the issuer when
interest rate goes up.

Convertible Bond
• Investors have the option to replace • Convertible bonds are issued at lower
bond with specified number of shares coupon rates and also there is debt
incase of price appreciation & not elimination incase bonds are
affected by price depreciation as it redeemed
has no impact on the interest
payment.
FACTORS FOR FACTORS AGAINST

Callable Bond
 Prevents interest rate risk to the issuer  There will be forgone coupon payment
at all means as the issuer of the bond is as they are normally issued at a
always on the safe side either the discount.
interest rate falls or goes up.

Puttable Bond
 The bondholder/ investor is always  Price of puttable bond is always higher
entitled prevailing coupon rate as the than price of straight bonds
issuer is left to give higher coupon rate
or sell the bond at deep discount.

Convertible Bond
 It is a hybrid security with both debt  The firm may not be interested in
and equity features raising more shares