Fixed Income Markets: Management, Trading and Hedging, 2nd Edition

CHAPTER 8 Bonds with Embedded Options and Option-Adjusted Spread Analysis

In Chapter 1 we reviewed the yield-to-maturity calculation, the main measure of bond return used in the fixed-income markets. For conventional bonds, the yield calculation is relatively straightforward because the issue’s redemption date is fixed. This means that the future cash flows that make up the total cash flows of the bond are known with certainty. As a result, data required to calculate the yield to maturity is known with certainty. Callable, put-able, and sinking-fund bonds, generally termed bonds with embedded options, are not as straightforward to analyse. This is because some aspect of their cash flows, such as the timing or the value of their future payments, is not certain. The term embedded is used because the option element cannot be separated from the bond itself. Since callable bonds have more than one possible redemption date, the collection of future cash flows contributing to their overall return is not clearly defined. If we wish to calculate the yield to maturity for such bonds, we must assume a particular redemption date and calculate the yield to this date. The market convention is to assume the first possible maturity date as the one to be used for yield calculation if the bond is priced above par, and the last possible date if the bond is priced below par. The term yield-to-worst is sometimes used to refer to a redemption-yield calculation made under this assumption; this is ...