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If rates go down, many home owners will refinance at a lower rate. As a consequence, the agencies lose assets. By issuing numerous callable bonds, they have a natural hedge, as they can then call their own issues and refinance at a lower rate. The price behaviour of a callable bond is the opposite of that of puttable bond.
The call price is the price the issuer can call the bond, usually at the par price. Buy the bond: Once you buy the bond, its terms begin. The investment will grow at the specified interest rate.
Securities other than bonds that may have embedded options include senior equity, convertible preferred stock and exchangeable preferred stock. See Convertible security. [citation needed] The valuation of these securities couples bond-or equity-valuation, as appropriate, with option pricing. For bonds here, there are two main approaches, as ...
Bonds of this type include: Callable bond: allows the issuer to buy back the bond at a predetermined price at a certain time in future. The holder of such a bond has, in effect, sold a call option to the issuer. Callable bonds cannot be called for the first few years of their life. This period is known as the lock out period.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. These are called callable bonds. [10] A less common feature is an embedded put option that allows investors to put the bond back to the issuer before its maturity date. These are called putable bonds.
Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss – thus callable bonds will typically be issued at a higher coupon rate, reflecting the value of the option.
A variant on the Binomial, is the Trinomial tree, [10] [11] developed by Phelim Boyle in 1986. Here, the share price may remain unchanged over the time-step, and option valuation is then based on the value of the share at the up-, down- and middle-nodes in the later time-step. As for the binomial, a similar (although smaller) range of methods ...
Yield to put (YTP): same as yield to call, but when the bond holder has the option to sell the bond back to the issuer at a fixed price on specified date. Yield to worst (YTW): when a bond is callable, puttable, exchangeable, or has other features, the yield to worst is the lowest yield of yield to maturity, yield to call, yield to put, and others.