CHAPTER 9

Valuation and Analysis:

Bonds with Embedded Options

Saïd Boukendour, PhD.

Part-time professor
Fall 2022

© 2020 CFA Institute. All rights reserved.

CONTENTS
1 Introduction
2 Overview of Embedded Options
3 Valuation and Analysis of Callable and Putable Bonds
4 Interest Rate Risk of Bonds with Embedded Options
5 Valuation and Analysis of Capped and Floored
Floating-Rate Bonds
6 Valuation and Analysis of Convertible Bonds
7 Bond Analytics
8 Summary

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© 2020 CFA Institute. All rights reserved.
 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.

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 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.”

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 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.

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 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.

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 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.

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 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

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 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.

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 VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS
Example (continued):
Today 1 Year 2 Year 3 Year

Cash Flow 4.250 4.250 104.250

Forward Rate 2.500% 3.518% 4.564%

Value of the =101.707 =100.417 =99.7

Callable Bond Called at 100 Not called

Value of the =102.397 =100.707 =99.7

Putable Bond Not put Put at 100

Value of Option- =102.114 =100.417 =99.7

Free Bond

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 VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS
Example (continued):

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

embedded 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

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 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.

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 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).

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 YIELD CURVE EFFECTS
For a putable bond:

If the yield curve shifts up, the

value of the putable bond falls less
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).

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 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.

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 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
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 at par and (2) putable at par:
5.5258%

3.8695%

2.5% 4.5245%

3.1681%
3.7041%

Year 0 Year 1 Year 2

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 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
(1) Callable Bond
98.791 104.250
5.5258%

99.658 4.250
3.8695%

101.540 4.250 99.738 104.250

2.500% 4.5242%

100 4.250
100.922
3.1681%
100 104.250
100.526
3.7041%

Year 0 Year 1 Year 2 Year 3

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 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
(2) Putable Bond 100
98.791 104.250
5.5258%
100.366
4.250
3.8695%

102.522 100 104.250

4.250 99.738
2.500%
4.5242%

101.304 4.250
3.1681%

100.526 104.250
3.7041%

Year 0 Year 1 Year 2 Year 3

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 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.

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 VALUATION OF RISKY CALLABLE
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.

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 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
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.

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 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.

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CALCULATING A BOND’S EFFECTIVE DURATION
IN PRACTICE
In practice, the estimation procedure is usually as follows:
Shift the
Given a Shift the benchmark
price benchmark yield curve
(PV0), yield curve up by the
calculate down, same
the implied generate a magnitude,
new interest generate a Calculate
OAS to the the
benchmar rate tree, and new interest
then revalue rate tree, and bond’s
k yield effective
curve at the bond then revalue
using the the bond duration.
an
appropriat OAS using the
e interest calculated in OAS
rate Step 1. This calculated in
volatility value is PV–. Step 1. This
value is PV+.
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 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.

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 ONE-SIDED DURATION
AND KEY RATE DURATION

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

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

Key rate duration

reflects the sensitivity • Key rate durations help portfolio managers
of the bond’s price to and risk managers identify the “shaping risk”
changes in specific for bonds — that is, the bond’s sensitivity to
maturities on the changes in the shape of the yield curve (e.g.,
benchmark yield steepening and flattening).
curve.

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 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.

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 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 4.50% at 10%

interest rate volatility. The interest rate tree is the same as in earlier
examples.
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 VALUATION OF A CAPPED FLOATER
4.50% Capped Floater
99.028 104.5000
5.5258% 105.5258

99.521 3.8695
3.8695%

99.761 2.5000 99.977 104.5000

2.5000% 4.5242% 104.5242
99.989 3.1681
3.1681%

100.000 103.7041
Value of embedded cap 3.7041%
= 100 – 99.761 = 0.239

Year 0 Year 1 Year 2 Year 3

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 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.

Value of Value of Value of

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.

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 VALUATION OF A FLOORED FLOATER
3.50% Floored Floater
100.000 105.5258
5.5258%

100.000 3.8695
3.8695%

101.133 3.5000 100.000 104.5242

2.5000% 2.5000 4.5242%

100.322 3.5000
3.1681% 3.1681
100.000 103.7041
Value of embedded floor 3.7041%
= 101.133 – 100 = 1.133

Year 0 Year 1 Year 2 Year 3

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 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).

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 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
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 MARKET CONVERSION PRICE AND PREMIUM
• The market 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:

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 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.

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

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 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.

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 7. BOND ANALYTICS
• Some market participants, in particular financial institutions,
develop bond analysis systems 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.

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 8. SUMMARY
Fixed-income securities with embedded options
• An embedded option represents a right that can be
exercised by the issuer, by the bondholder, or automatically
depending on the course of interest rates.

• Simple embedded option structures include call options, put

options, and extension options.

• Complex embedded option structures include bonds with

other types of options or combinations of options, including a
conversion option, an estate put, or an acceleration
provision for a sinking fund.

38
© 2020 CFA Institute. All rights reserved.
 SUMMARY
Relationships between the values of a callable or putable bond,
the underlying option-free bond, and the embedded option

• The value of a bond with an embedded option is equal to the

arbitrage-free values of its parts—that is, the arbitrage-free
value of the straight bond and the arbitrage-free values of
each of the embedded options.

Arbitrage-free framework can be used to value a bond with

embedded options

• The value of a callable or putable bond can be calculated by

discounting the bond’s future cash flows at the appropriate
one-period forward rates, taking into consideration the
decision to exercise the option.

39
© 2020 CFA Institute. All rights reserved.
 SUMMARY
Interest rate volatility and value of a callable/putable bond
• Interest rate volatility is modeled using a binomial interest
rate tree. The higher the volatility, the lower the value of the
callable bond and the higher the value of the putable bond.
• Changes in the level and shape of the yield curve affect the
values of bonds with embedded options.

Valuing a callable/putable bond from an interest rate tree

• Valuing a bond with embedded options assuming an interest
rate volatility requires three steps: (1) Generate a tree of
interest rates based on the given yield curve and volatility
assumptions; (2) at each node of the tree, determine
whether the embedded options will be exercised; and (3)
apply the backward induction valuation methodology to
calculate the present value of the bond.

40
© 2020 CFA Institute. All rights reserved.
 SUMMARY
Option-adjusted spreads

• The option-adjusted spread is the single spread added

uniformly to the one-period forward rates on the tree to
produce a value or price for a bond.
• The OAS is sensitive to interest rate volatility: The higher the
volatility, the lower the OAS for a callable bond.

Effective duration of a callable/putable bond

• For bonds with embedded options, the best measure to

assess the sensitivity of the bond’s price to a parallel shift of
the benchmark yield curve is effective duration.
• The effective duration of a callable or putable bond cannot
exceed that of the straight bond.

41
© 2020 CFA Institute. All rights reserved.
 SUMMARY
One-sided and key rate durations
• Because the prices of callable and putable bonds respond
asymmetrically to upward and downward interest rate
changes of the same magnitude, one-sided durations can
provide a better indication regarding the interest rate
sensitivity of bonds with embedded options than (two-sided)
effective duration.
• Key rate durations show the effect of shifting only key points,
one at a time, rather than the entire yield curve.

Effective convexities of callable, putable, and straight bonds

• When the option is near the money, the convexity of a
callable bond is negative, indicating that the up side for a
callable bond is much smaller than the down side, whereas
the convexity of a putable bond is positive, indicating that the
up side for a putable bond is much larger than the downside.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Capped or floored floating-rate bond

• The value of a capped floater is equal to or less than the

value of the straight bond.
• The value of a floored floater is equal to or higher than the
value of the straight bond.

Defining features of a convertible bond

• The characteristics of a convertible bond include the

conversion price, which is the applicable share price at
which the bondholders can convert their bonds into common
shares, and the conversion ratio, which reflects the number
of shares of common stock that the bondholders receive
from converting their bonds into shares.

43
© 2020 CFA Institute. All rights reserved.
 SUMMARY
Valuation of a convertible bond

• There are a number of investment metrics and ratios that

help analyze and value convertible bonds. The conversion
value indicates the value of the bond if it is converted at the
market price of the shares. The minimum value of a
convertible bond sets a floor value for the convertible bond
at the greater of the conversion value or the straight value.

• The arbitrage-free framework can be used to value

convertible bonds, including callable and putable ones. Each
component (straight bond, call option of the stock, and call
and/or put option on the bond) can be valued separately.

44
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 SUMMARY
Risk–return characteristics of a convertible bond

• The risk–return characteristics of a convertible bond depend

on the underlying share price relative to the conversion
price. When the underlying share price is well below the
conversion price, the convertible bond is “busted” and
exhibits mostly bond risk–return characteristics.

• In contrast, when the underlying share price is well above

the conversion price, the convertible bond exhibits mostly
stock risk–return characteristics.

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© 2020 CFA Institute. All rights reserved.