Mastering Attribution in Finance

21

Options and callable bonds

21.1 Introduction

21.2 Measuring yield on bonds with embedded options

21.3 Optionality in practice

21.1 INTRODUCTION

A bond with an embedded call has the property that, on certain dates, the issuer can withdraw the bond and return the principal, plus any accrued interest, to the purchaser. For the bondholder, this means that their funds, which were safely invested, will now have to be invested somewhere else.

This reinvestment risk adds extra uncertainty for the bondholder. To compensate for the possibility of lower future income, a bond with a call option trades at a higher yield than a similar security with no optionality.

Conversely, a bond with an embedded put allows the bondholder to exchange the bond ...