VALUATION AND ANALYSIS:

BONDS WITH EMBEDDED OPTIONS

CHAPTER 9

© 2016 CFA Institute. All rights reserved.

TABLE OF CONTENTS
01 INTRODUCTION
02 OVERVIEW OF EMBEDDED OPTIONS
03 VALUATION AND ANALYSIS OF CALLABLE AND PUTABLE BONDS
04 INTEREST RATE RISK OF BONDS WITH EMBEDDED OPTIONS
05 VALUATION AND ANALYSIS OF CAPPED AND FLOORED FLOATING-
RATE BONDS
06 VALUATION AND ANALYSIS OF CONVERTIBLE BONDS
07 BOND ANALYTICS
08 SUMMARY

2
 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.

3
 2. OVERVIEW OF EMBEDDED OPTIONS

The term These options are

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

4
 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. (interest rates drop)
• 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.

5
 CALL OPTIONS
• European-style: call option may only be exercised by
issuer on a single date at the end of the lockout period.

• American-style: call option may be exercised by issuer

on any date from end of the lockout period until maturity
(continuously callable).

• Bermudan-style: call option may only be exercised on a

predetermined schedule of dates after the end of the
lockout period.

6
 CALL OPTIONS
• Bonds issued by Government-sponsored enterprises
(GSE) like Fannie Mae, Freddie Mac, Federal Home Loan
Banks and Federal Farm Credit Banks are almost always
callable. They have short maturities (5-10 years) and short
lockout periods (3 months-1 year). Bonds are callable at
100% of par and the option is often Bermudan-style.
• Municipal bonds are almost always callable at 100% of par
any time after the 10 year of maturity.
• Municipal bonds and GSE bonds represent the majority of
callable bonds issued and traded globally.
• Most callable bonds are issued in U.S. dollars or Euros.

7
 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. This usually happens when
interest rates rise and higher-yielding bonds are available.

• 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.

8
 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 (i.e. estate put)

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.

9
 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

10
 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. (Zero volatility in
interest rates means we do not use the binomial interest rate tree
model from the previous chapter, but just a straight timeline.)

11
 VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS
Callable Bonds
When the yield on a bond falls to below the coupon rate
(bond is trading at a premium > 100 percent of PAR), call
option is “in the money” and issuer may call bond at PAR,
replacing it with a lower coupon bond.

Putable Bonds
When the yield on a bond rises to above the coupon rate
(bond is trading at a discount < 100 percent of PAR), put
option is “in the money” and investor may put the bond back
to the issuer at PAR, using the proceeds to invest in a new,
higher-coupon bond.
12
VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS

13
 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
Discount 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 =102.114 =100.417 =99.7

Option-Free
Bond

14
 VALUATION OF DEFAULT-FREE
AND OPTION-FREE BONDS
Example (continued).

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

15
 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.

16
INTEREST RATE VOLATILITY

17
INTEREST RATE VOLATILITY

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).

19
YIELD CURVE EFFECTS

20
YIELD CURVE EFFECTS

21
 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).

22
YIELD CURVE EFFECTS

23
YIELD CURVE EFFECTS

24
 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.

25
 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 and 2) putable at par:
 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY

27
 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
• Valuation of nodes in the binomial tree for callable bond in Exhibit 12
Vuu = 0.5*[104.250/1.055258 + 104.250/1.055258] = 98.791
Vud = 0.5*[104.250/1.045242 + 104.250/1.045242] = 99.738
Vdd = 0.5*[104.250/1.037041 + 104.250/1.037041] = 100.526 100.000
Vu = 0.5*[(98.791+4.250)/1.038695 + (99.738+4.250)/1.038695] = 99.658
Vd = 0.5*[(100.000+4.250)/1.031681 + (99.738+4.250)/1.031681] = 100.922 100.000
Vo = 0.5*[(99.658+4.250)/1.025000 + (100.000+4.250)/1.025000] = 101.540

28
29
30
 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY

31
 VALUATION OF DEFAULT-FREE CALLABLE AND
PUTABLE BONDS WITH INTEREST RATE VOLATILITY
• Valuation of nodes in the binomial tree for putable bond in Exhibit 13
Vuu = 0.5*[104.250/1.055258 + 104.250/1.055258] = 98.791 100.000
Vud = 0.5*[104.250/1.045242 + 104.250/1.045242] = 99.738 100.000
Vdd = 0.5*[104.250/1.037041 + 104.250/1.037041] = 100.526
Vu = 0.5*[(100.000+4.250)/1.038695 + (100.000+4.250)/1.038695] = 100.366
Vd = 0.5*[(100.000+4.250)/1.031681 + (100.526+4.250)/1.031681] = 101.304
Vo = 0.5*[(100.366+4.250)/1.025000 + (101.304+4.250)/1.025000] = 102.522

32
 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.

33
 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 derived from the default-free benchmark
bond: 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.

34
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
Determining the yield curve for a risky bond from the
risk-free benchmark yield curve - using the Z-spread.
• The Z-spread, also known as the zero-volatility spread, is calculated
as a constant yield spread over a government (or interest rate swap)
spot curve.

• The Z-spread is calculated using an iterative calculation approach.

The values of the spot rates z1, z2, etc... are obtained from the risk-free
benchmark yield curve. The target risky bond is selected, and PMT
and FV are set to the coupon and par value of that bond. Then, the
value of "Z" is iteratively adjusted until the PV = the market price of the
risky bond.

35
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
• The Z-spread is called the "zero-volatility spread" because it
does not take into account any variation in interest rates over
time. The same value of "Z" is used to adjust the spot rates for
all maturities.
• The Z-spread includes the
- credit risk,
- liquidity risk, and
- option risk
that are associated with the risky bond, over and above the risk-
free benchmark bond spot rates.
• A more appropriate adjustment to the benchmark rates for bonds
with embedded options is the Option Adjusted Spread (OAS).

36
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
• The OAS is the constant spread that, when added to the one-period
forward rates in the binomial interest rate tree, will make the arbitrage-
free value of the risky bond equal to its market price.
• Like the calculation for the Z-spread, the calculation for the OAS is
done by an iterative calculation approach. However the OAS uses the
binomial tree with the value at each node adjusted for the option.
• Exhibit 12 on the following page shows the valuation of a risk-free
callable bond using benchmark forward rates. Note how the node
values have been adjusted for the call option.
• Exhibit 15 following that assumes the bond is risky, sets the market
price to $101.000 and then iteratively calculates the OAS that would
have to be added to every one-year forward rate to produce that
market price. The OAS value determined is 28.55 bps.
• The OAS includes default risk and liquidity risk, but does NOT include
option risk, unlike the Z-spread which includes all three.
37
VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS

38
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS

OAS = 28.55 bps

39
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
Valuing RISKY callable and putable bonds using the
binomial tree method.
1. Generate the risk-free binomial tree using the benchmark
implied forward rates as shown in Chapter 8.
2. Go through the tree and add the OAS to the interest rate in
every node in the tree. Now you have a binomial tree calibrated
to value risky bonds.
3. Use the backward induction method, starting at the rightmost
nodes of the tree, to evaluate leftward through the tree to
determine V0.
- For a Callable bond, set every node with V>100 to V=100
- For a Putable bond, set every node with V<100 to V=100

40
 VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS
OAS can be used as a measure of the value of the bond
relative to a benchmark.
• If the OAS is lower than the OAS for a bond with similar
characteristics and credit quality, the bond is overpriced and
should be avoided.
• If the OAS is higher than the OAS for a bond with similar
characteristics and credit quality, the bond is underpriced and is
desirable.
• If the OAS is similar to the OAS for a bond with similar
characteristics and credit quality, the bond is fairly priced.

41
 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.

42
VALUATION OF RISKY CALLABLE
AND PUTABLE BONDS

43
 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
(yield duration) or to changes in benchmark interest rates
(curve duration).
• For bonds with embedded options, the only appropriate
duration measure is the curve duration measure known as
effective (or
Effective option-adjusted)
duration 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.

44
 CALCULATING A BOND’S EFFECTIVE DURATION
IN PRACTICE
In practice, the estimation procedure is usually as follows:
Shift the
benchmark Shift the
yield curve benchmark
Given a
down, yield curve up
price (PV0), generate a by the same
calculate new magnitude,
the implied interest rate generate a Calculate
OAS to the tree, and new interest the bond’s
benchmark then rate tree, and effective
yield curve revalue the then revalue duration.
at an bond using the bond
appropriate the OAS using the OAS
interest rate calculated calculated in
volatility in Step 1. Step 1. This
This value value is PV+.
is PV–.
45
OAS = 28.55 bps

PV0 = 101.000

46
∆Curve = -30 bps

PV- = 101.599

47
∆Curve = +30 bps

PV+ = 100.407

48
CALCULATING A BOND’S EFFECTIVE DURATION
IN PRACTICE

= = 1.97

This effective duration indicates that a 1% (100 bps)

increase in interest rates would reduce the value of
this callable bond by 1.97%

49
 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. (call option is "out of the money")
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. (put option is "out of the money")
When interest rates rise, the effective duration of the
putable bond is lower than that of the straight bond.

50
 INTEREST RATE RISK OF BONDS WITH
EMBEDDED OPTIONS
Type of Bond Effective Duration
Cash = zero
Zero-coupon bond = maturity
Fixed-rate bond < maturity
Callable bond ≤ duration of straight bond
as interest rates fall (bond price rises), call option moves
into the money and the bond is more likely to be called.
Effective duration falls.
Putable bond ≤ duration of straight bond
as interest rates rise (bond price falls), put option moves into
the money and the bond is more likely to be put. Effective
duration falls.
Floater (Libor flat) ≈ time (in years) to next reset

51
 ONE-SIDED DURATION
AND KEY RATE DURATION

• It is better at capturing the interest rate

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

Key rate duration • Key rate durations help portfolio managers

reflects the sensitivity and risk managers identify the “shaping
of the 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.

52
 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.

53
EFFECTIVE CONVEXITY

54
EFFECTIVE CONVEXITY

55
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
stock, which gives bondholders
the right to convert their debt into
equity during a pre-determined
period (known as the conversion
period) at a pre-determined price
(known as the conversion price).
The number of shares of
common stock that the
bondholder receives from
converting the bonds into
shares is called the
“conversion ratio.”

56
 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
57
 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:

58
 MARKET CONVERSION PRICE AND PREMIUM
EXAMPLE: Assume a convertible bond has a PAR value of $1000, a conversion
ratio of 20 and a current market price of 101.250 percent of PAR. Assume the
price of a share of the firm’s stock is currently $49.950.
a) What is the conversion value of the bond?
Conversion value = Share price x Conversion ratio = $49.950x20 = $999.000
b) What is the straight value of the bond?
It is quoted by the market as 101.250 percent of PAR = $1012.500
c) What is the minimum (or floor) value of the convertible bond?
It is the higher of the conversion value and the straight value, or $1012.500 The
investor would not sell the bond for less than this.
d) What is the market conversion price per share?
= $1012.50/20 = $50.625

59
 MARKET CONVERSION PRICE AND PREMIUM
EXAMPLE (continued): Assume a convertible bond has a PAR value of $1000,
a conversion ratio of 20 and a current market price of 101.250 percent of PAR.
Assume the price of a share of the firm’s stock is currently $49.950.
e) What is the market conversion premium per share?
Market conversion premium per share = Market conversion price – Underlying
share price = $50.625 - $49.950 = $0.675
f) What is the market conversion premium ratio?
= $0.675/$49.950 = -1.351%
Should the investor convert the bond to stock? If she did so today, she would be
converting a bond worth $1012.500 as a bond into $999.000 worth of stock. Not a good
deal unless she expected the stock to experience a large increase in price quickly. When
the market price of the stock exceeds the conversion price of $50.625, the bond becomes
worth more as stock than as a bond. If the investor believes that the stock price will persist
at the new higher value, she may convert the bond to stock at that time.

60
 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.

61
 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

62
 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.

63
 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 on interest rate volatility.
Check that the volatility term structure slopes downward.

64
 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.

65
 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.

66
 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.

67
 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.

68
 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
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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 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.

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 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.

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 8. 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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