Chapter 14

Bonds with Embedded

Options and Options on
Bonds
FIXED-INCOME SECURITIES
Outline
Callable and Putable Bonds
Institutional Aspects
Valuation
Convertible Bonds
Institutional Aspects
Valuation
Options on Bonds
Institutional Aspects
Valuation
Uses
Callable Bonds and Putable Bonds
Bond with Embedded Options
Callable bonds
Issuer may repurchase at a pre-specified call price
Typically called if interest rates fall
A callable bond has two disadvantages for an investor
If it is effectively called, the investor will have to invest in another bond
yielding a lower rate
A callable bond has the unpleasant property for an investor to appreciate
less than a normal similar bond when interest rates fall
Therefore, an investor will be willing to buy such a bond at a lower price
than a comparable option-free bond
Examples
The UK Treasury bond with coupon 5.5% and maturity date 09/10/2012 can
be called in full or part from 09/10/2008 on at a price of pounds 100
The US Treasury bond with coupon 7.625% and maturity date 02/15/2007
can be called on coupon dates only, at a price of $100, from 02/15/2002 on
Such a bond is said to be discretely callable
Callable and Putable Bonds
Institutional Aspects
Putable bond holder may retire at a pre-specified
price
A putable bond allows its holder to sell the bond at
par value prior to maturity in case interest rates
exceed the coupon rate of the issue
So, he will have the opportunity to buy a new bond at
a higher coupon rate
The issuer of this bond will have to issue another
bond at a higher coupon rate if the put option is
exercised
Hence a putable bond trades at a higher price than a
comparable option-free bond
Callable and Putable Bonds
Yield-to-Worst
Let us consider a bond with an embedded call option
trading over its par value
This bond can be redeemed by its issuer prior to
maturity, from its first call date on
One can compute a yield-to-call on all possible call dates
The yield-to-worst is the lowest of the yield-to-maturity and all yields-to-call
Example
10-year bond bearing an interest coupon of 5%, discretely callable after 5
years and trading at 102
There are 5 possible call dates before maturity
Yield-to-worst is 4.54%
Yield-to-call
year 5 4.54%
year 6 4.61%
year 7 4.66%
year 8 4.69%
year 9 4.72%
Yield-to-maturity
year 10 4.74%
Callable and Putable Bonds
Valuation in a Binomial Model
Let us assume that a binomial tree has been already
built and calibrated as explained in Chapter 12
Recursive procedure
Price cash-flow to be discounted on period n-1 is the minimum value of the
price computed on period n and call price on period n
And so on until we get the price P of the callable bond
Example
We consider a callable bond with maturity two years, annual coupon 5%,
callable in one year at 100
r
0
= 4%, r
u
= 4.66% and r
l
= 4.57% (cf. example in Chapter 12)
We have P
u
= 105/1.0466 = 100.32 and P
l
= 105/1.0457 = 100.41
Finally, price of the callable bond
( ) ( )
96 . 100
% 4 1
5 41 . 100 , 100 min
% 4 1
5 32 . 100 , 100 min
2
1
=

+
+
+
+
+
= P
Callable and Putable Bonds
Monte Carlo Approach
Step 1: generate a large number of short-term interest rate
paths using some dynamic model (see Chapter 12)
Step 2: along each interest rate path, the price P of the bond
with embedded option is recursively determined
The price of the bond is computed as the average of its prices
along all interest rate paths
Period Path1 Path2 Path3 Path4 Path5 Path6
1 4,00% 4,00% 4,00% 4,00% 4,00% 4,00%
2 4,08% 4,14% 4,29% 4,24% 4,28% 4,28%
3 3,83% 4,02% 4,35% 4,27% 4,24% 4,23%
4 4,15% 3,88% 4,25% 3,87% 4,17% 4,30%
5 4,27% 4,26% 4,68% 4,58% 4,29% 3,99%
6 4,69% 4,49% 4,33% 4,29% 4,47% 4,32%
7 4,88% 5,10% 5,24% 5,08% 5,27% 4,70%
8 5,14% 4,94% 4,75% 5,54% 5,25% 5,08%
9 5,24% 5,47% 5,15% 5,26% 5,43% 5,64%
10 5,59% 5,04% 5,29% 5,58% 5,38% 5,02%
Callable and Putable Bonds
Monte Carlo Approach - Example
Price a callable bond with annual coupon 4.57%,
maturity 10 years, redemption value 100 and callable
at 100 after 5 years
Prices of the bond under each scenario
Path1 Path2 Path3 Path4 Path5 Path6
Price of the callable bond 100.43 100.55 99.90 99.76 99.68 100.55
Price of the bond is average over all paths
P=1/6(100.43+100.55+99.9+99.76+99.68+100.55)=100.14
The Monte Carlo pricing methodology can also be
applied to the valuation of all kinds of interest rates
derivatives
Convertible Bonds
Definition
Convertible securities are usually either convertible bonds or
convertible preferred shares which are most often
exchangeable into the common stock of the company issuing
the convertible security
Being debt or preferred instruments, they have an advantage to
the common stock in case of distress or bankruptcy
Convertible bonds offer the investor the safety of a fixed income
instrument coupled with participation in the upside of the equity
markets
Essentially, convertible bonds are bonds that, at the holder's
option, are convertible into a specified number of shares
Convertible Bonds
Terminology
Convertible bonds
Bondholder has a right to covert bond for pre-specified number of
share of common stock
Terminology
Convertible price is the price of the convertible bond
Bond floor or investment value is the price of the bond if there is no
conversion option
Conversion ratio is the number of shares that is exchanged for a
bond
Conversion value = current share price x conversion ratio
Conversion premium = (convertible price conversion value) /
conversion value
Income pickup is the amount by which the yield to maturity of the
convertible bond exceeds the dividend yield of the share
Convertible Bonds
Examples
Example 1:
Current bond price = $930
Conversion ratio: 1 bond = 30 shares common
Current stock price = $25/share
Market Conversion Value = (30 shares)x(25) = $750
Conversion Premium = (930 750) / 750 = 180 / 750 = 24%
Example 2: AXA Convertible Bond
AXA has issued in the zone a convertible bond paying a 2.5% coupon
rate and maturing on 01/01/2014; the conversion ratio is 4.04
On 12/13/2001, the current share price was 24.12 and the bid-ask
convertible price was 156.5971/157.5971
The conversion value was equal to 97.44 = 4.04 x 24.12
The conversion premium calculated with the ask price 157.5971 was
61.73% = (157.5791 - 97.44)/ 97.44
The conversion of the bond into 4.04 shares can be executed on any date
before the maturity date
Convertible Bonds
Bloomberg Description
Convertible Bonds
Uses
For the issuer
Issuing convertible bonds enables a firm to obtain better financial
conditions
Coupon rate of such a bond is always lower to that of a bullet bond with the
same characteristics in terms of maturity and coupon frequency
This comes directly from the conversion advantage which is attached to
this product
Besides the exchange of bonds for shares diminishes the liabilities of the
firm issuer and increases in the same time its equity so that its debt
capacity is improved
For the convertible bondholder
The convertible bond is a defensive security, very sensitive to a rise in the
share price and protective when the share price decreases
If the share price increases, the convertible price will also increase
When share price decreases, price of convertible never gets below the
bond floor, i.e., the price of an otherwise identical bullet bond with no
conversion option
Convertible Bonds
Determinants of Convertible Bond Prices
Convertible bond is similar to a normal coupon bond
plus a call option on the underlying stock
With an important difference: the effective strike price of the call option will
vary with the price of the bond
Convertible securities are priced as a function of
The price of the underlying stock
Expected future volatility of equity returns
Risk free interest rates
Call provisions
Supply and demand for specific issues
Issue-specific corporate/Treasury yield spread
Expected volatility of interest rates and spreads
Thus, there is large room for relative mis-valuations
Convertible Bonds
Convertible Bond Price as a Function of Stock Price
P arity
B ond
P rice
S traight B ond
S tock P rice
C onvertible
B ond
Convertible Bonds
Convertible Bond Pricing Model
A popular method for pricing convertible bonds is the
component model
The convertible bond is divided into a straight bond component and a call
option on the conversion price, with strike price equal to the value of the
straight bond component
The fair value of the two components can be calculated with standard
formulas, such as the famous Black-Scholes valuation formula.
This pricing approach, however, has several
drawbacks
First, separating the convertible into a bond component and an option
component relies on restrictive assumptions, such as the absence of
embedded options (callability and putability, for instance, are convertible
bond features that cannot be considered in the above separation)
Second, convertible bonds contain an option component with a stochastic
strike price equal to the bond price
Convertible Bonds
Convertible Bond Pricing Models
Theoretical research on convertible bond pricing was
initiated by Ingersoll (1977a) and Brennan and
Schwartz (1977), who both applied the contingent
claims approach to the valuation of convertible
bonds.
In their valuation models, the convertible bond price
depends on the firm value as the underlying variable.
Brennan and Schwartz (1980) extend their model by
including stochastic interest rates.
These models rely heavily on the theory of stochastic
processes and require a relatively high level of
mathematical sophistication
The price of the stock only can go up to a
given value or down to a given value
S
uS
dS
Besides, there is a bond (bank account) that
will pay interest of r
Convertible Bonds
Binomial Model
We assume u (up) > d (down)
For Black and Scholes we will need d = 1/u
For consistency we also need u > (1+r) > d
Example: u = 1.25; d = 0.80; r = 10%
S=100
S = 125
S = 80
Convertible Bonds
Binomial Model
Basic model that describes a simple world.
As the number of steps increases, it becomes
more realistic
We will price and hedge an option: it applies
to any other derivative security
Key: we have the same number of states and
securities (complete markets)
Basis for arbitrage pricing
Convertible Bonds
Binomial Model
Introduce an European call option:
K = 110
It matures at the end of the period
S=100
uS= 125
dS= 80
S C (K=110)
C
u
= 15
C
d
= 0
Convertible Bonds
Binomial Model
We can replicate the option with the stock
and the bond
Construct a portfolio that pays C
u
in state u
and C
d
in state d
The price of that portfolio has to be the same
as the price of the option
Otherwise there will be an arbitrage
opportunity
Convertible Bonds
Binomial Model
We buy shares and invest B in the bank
They can be positive (buy or deposit) or negative
(shortsell or borrow)
We want then,

= + +
= + +
d
u
C r B dS
C r B uS
) 1 (
) 1 (
With solution,
) 1 )( (
;
) ( r d u
C d C u
B
d u S
C C
u d d u
+

=

=
Convertible Bonds
Binomial Model
In our example, we get for stock:
3
1
8 0 25 1 100
0 15
=


=

=
) . . ( d) S(u
C C

d u
And, for bonds:
24 . 24
) 1 . 1 ( ) 8 . 0 25 . 1 (
15 8 . 0 0 25 . 1
) 1 )( (
=


=
+

=
r d u
C d C u
B
u d
The cost of the portfolio is,
09 . 9 24 . 24 100
3
1
= = + B S
Convertible Bonds
Binomial Model
The price of the European call must be 9.09.
Otherwise, there is an arbitrage opportunity.
If the price is lower than 9.09 we would buy
the call and shortsell the portfolio
If higher, the opposite
We have computed the price and the hedge
simultaneously:
We can construct a call by buying the stock and borrowing
Short call: the opposite
Convertible Bonds
Binomial Model
Remember that
) 1 )( (
;
) ( r d u
C d C u
B
d u S
C C
u d d u
+

=

=
And
B S C + =
Substituting,
) 1 )( ( ) ( r d u
C d C u
d u
C C
C
u d d u
+

+

=
Convertible Bonds
Binomial Model
After some algebra,

+
+

+
=
d u
C
d u
r u
C
d u
d r
r
C
) (
) 1 (
) (
1
1
1
Observe the coefficients,
) (
) 1 (
,
) (
1
d u
r u
d u
d r

+
Positive
Smaller than one
Add up to one
Like a probability.
Convertible Bonds
Binomial Model
Rewrite
[ ]
d u
C p C p
r
C +
+
= ) 1 (
1
1
Where
) (
) 1 (
1 ,
) (
1
d u
r u
p
d u
d r
p

+
=

+
=
This would be the pricing of:
A risk neutral investor
With subjective probabilities p and (1-p)
Convertible Bonds
Binomial Model
Suppose the following economy,
S
uS
dS
u
2
S
udS
d
2
S
We introduce an European call with strike price K that
matures in the second period
Convertible Bonds
Binomial Model
The price of the option will be:
)] , 0 max( ) 1 ( 2
) , 0 max( ) 1 (
) , 0 max( [
) 1 (
1
2 2
2 2
2
K udS p p
K S d p
K S u p
r
C
+
+

+
=
There are two paths that lead to the intermediate
state (that explains the 2)
Suppose we know the volatility and the time to
maturity t, we can retrieve u and d (see B&S)
Convertible Bonds
Binomial Model
u d e u
n t
/ 1 ;
/
= =

Convertible Bond
Valuation Methodology
Given that a convertible bond is nothing but an
option on the underlying stock, we expect to be able
to use the binomial model to price it
At each node, we test
a. whether conversion is optimal
b. whether the position of the issuer can be improved by calling the bonds
It is a dynamic procedure: max(min(Q1,Q2),Q3)),
where
Q1 = value given by the rollback (neither converted nor called back)
Q2 = call price
Q3 = value of stocks if conversion takes place
Convertible Bond
Example
Example
We assume that the underlying stock price trades at $50.00 with a
30% annual volatility
We consider a convertible bond with a 9 months maturity, a
conversion ratio of 20
The convertible bond has a $1,000.00 face value, a 4% annual
coupon
We further assume that the risk-free rate is a (continuously
compounded) 10%, while the yield to maturity on straight bonds
issued by the same company is a (continuously compounded) 15%
We also assume that the call price is $1,100.00
Use a 3 periods binomial model (t/n=3 months, or year)
Convertible Bond
Example
We have
d u
d r
p
u
d
e u

+
=
= =
= =
1
.8607
1
1618 . 1
4 / 1 3 .
Actually (continuously compounded rate)
.547
8607 . 1618 . 1
8607 .
4
% 10
exp
=

= p
Convertible Bond
Example
$78.42
G 10.00% looks like a stock: use risk-free rate
$1,568.31 conversion: 78.42>1040/20=52
$67.49
D 10.00% calling or converting does not change the bond value because it is already essentially equity
$1,349.86
$58.09 $58.09
B 11.03% H 10.00% looks like a stock: use risk-free rate
$1,191.13 $1,161.83 conversion: 58.09>1040/20=52
$50.00 $50.00
A 12.15% E 12.27% bond should not be converted because 1,073.18>50*20=1,000
$1,115.41 $1,073.18
$43.04 $43.04
C 13.51% I 15.00% looks like a risky bond: use risky rate
$1,006.23 $1,040.00 no conversion: 43.04<1040/20=52
$37.04
F 15.00% bond should not be converted because 1,001.72>50*20=1,000
$1,001.72
$31.88
J 15.00% looks like a risky bond: use risky rate
$1,040.00 conversion: 31.88<1040/20=52
Bond is Called
Convertible Bond
Example
At node G, the bondholder optimally choose to
convert since what is obtained under conversion
($1,568.31), is higher than the payoff under the
assumption of no conversion ($1,040.00)
The same applies to node H
On the other hand, at nodes I and J , the value under
the assumption of conversion is lower than if the
bond is not converted to equity
Therefore, bondholders optimally choose not to convert, and the payoff is
simply the nominal value of the bond, plus the interest payments, that is
$1,040.00
Convertible Bond
Example
Working our way backward the tree, we obtain at
node D the value of the convertible bond as the
discounted expected value, using risk-neutral
probabilities of the payoffs at nodes G and H
( ) ( ) 83 . 161 , 1 1 31 . 568 , 1 e = $1,349.86
% 10
12
3
-
+

p p
At node F, the same principle applies, except that it
can be regarded as a standard bond
We therefore use the rate of return on a non
convertible bond issued by the same company, 15%
( ) ( ) 040 , 1 1 040 , 1 e = $1,001.72
% 15
12
3
-
+

p p
Convertible Bond
Example
At node E, the situation is more interesting because the
convertible bond will end up as a stock in case of an up move
(conversion), and as a bond in case of a down move (no
conversion)
As an approximate rule of thumb, one may use a weighted
average of the riskfree and risky interest rate in the
computation, where the weighting is performed according to the
(risk-neutral) probability of an up versus a down move
px10% + (1-p)x15% = 12.27%
Then the value is computed as
( ) ( ) 040 , 1 1 83 . 161 , 1 e = $1,073.18
% 27 . 12
12
3
-
+

p p
Convertible Bond
Example
Note that at nodes D, E and F, calling or converting is not
relevant because it does not change the bond value since the
bond is already essentially equity
At node B, it can be shown that the issuer finds it optimal to call
the bond
If the bond is indeed called by the issuer, bondholders are left
with the choice between not converting and getting the call
price ($1,100), or converting and getting $20x58.09=1,161.8$,
which is what they optimally choose
This is less than $1,191.13, the value of the convertible bond if
it were not called, and this is precisely why it is called by the
issuer
Eventually, the value at node A, i.e., the present fair value of
the convertible bond, is computed as $1,115.41
Convertible Bond
Allowing for Stochastic Interest Rates
4.0%
4.5%
5.0%
3.6%
4.0%
3.2%
Interest Rate
Tree
$10
$12
$9
$8 $11 $14
Common Stock
Price Tree
Convertible Bonds
Convertible Arbitrage
Convertible arbitrage strategies attempt to exploit
anomalies in prices of corporate securities that are
convertible into common stocks
Roughly speaking, if the issuer does well, the
convertible bond behaves like a stock, if the issuer
does poorly, the convertible bond behaves like
distressed debt
Convertible bonds tends to be under-priced because
of market segmentation: investors discount securities
that are likely to change types
Convertible Bonds
Convertible Arbitrage
Convertible arbitrage hedge fund managers typically
buy (or sometimes sell) these securities and then
hedge part or all of the associated risks by shorting
the stock
Take for example Internet company AOL's zero
coupon converts due Dec. 6, 2019
These bonds are convertible into 5.8338 shares of AOL stock
With AOL common stock trading at $34.80 on Dec. 31, 2000, the
conversion value was $203 (=5.8338 x 34.80)
As the conversion value is significantly below the investment value
(calculated at $450.20), the investment value dominated and the
convertible traded at $474.10
When, or if, the stock trades above $77.15, the conversion value will
dominate the pricing of the convertible because it will be in excess of the
investment value
Convertible Bonds
Mechanism
In a typical convertible bond arbitrage position, the hedge fund
is not only long the convertible bond position, but also short an
appropriate amount of the underlying common stock
The number of shares shorted by the hedge fund manager is
designed to match or offset the sensitivity of the convertible
bond to common stock price changes
As the stock price decreases, the amount lost on the long
convertible position is countered by the amount gained on the
short stock position, theoretically creating a stable net position
value
As the stock price increases, the amount gained on the long
convertible position is countered by the amount lost on the
short stock position, theoretically creating a stable net position
value
This is known as delta hedging
Convertible Bonds
Mechanism
Parity =
Convertible
Bond
Convertible
Bond
Price
Stock Price
Delta =
Change in Price of Conv Bond
Change in Price of Stock
Stock Price
Conversion Ratio
Convertible Bonds
Mechanism
In the AOL example, the delta for the convertible is
approximately 50%
This means that for every $1 change in the conversion value,
the convertible bond price changes by 50 cents
To delta hedge the equity exposure in this bond we need to
short half the number of shares that the bond converts into, for
example 2.9 shares (5.8338\2)
The combined long convertible bond/short stock position should
be relatively insensitive to small changes in the price of AOL's
stock
Over-hedging is sometimes appropriate when there is concern
about default, as the excess short position may partially hedge
against a reduction in credit quality
Convertible Bonds
Risks Involved
Because a convertible bond is essentially a bond plus an option
to switch so that these strategies will typically
make money if expected volatility increases (long vega)
make money if the stock price increases rapidly (long gamma)
pay time-decay (short theta)
make money if the credit quality of the issuer improves (short the credit differential)
The risks involved relate to
changes in the price of the underlying stock (equity market risk)
changes in the interest rate level (fixed income market risk)
changes in the expected volatility of the stock (volatility risk)
changes in the credit standing of the issuer (credit risk)
The convertible bond market as a whole is also prone to
liquidity risk as demand can dry up periodically, and bid/ask
spreads on bonds can widen significantly
There is also the risk that the HF manager will be unable to
sustain the short position in the underlying common shares
In addition, convertible arbitrage hedge funds use varying
degrees of leverage, which can magnify both risks and returns
Options on Bonds
Terminology
An option is a contract in which the seller (writer)
grants the buyer the right to purchase from, or sell to,
the seller an underlying asset (here a bond) at a
specified price within a specified period of time
The seller grants this right to the buyer in exchange
for a certain sum of money called the option price or
option premium
The price at which the instrument may be bought or
sold is called the exercise or strike price
The date after which an option is void is called the
expiration date
An American option may be exercised any time up to and including the
expiration date
A European option may be exercised only on the expiration date
Options on Bonds
Factors that Influence Option Prices
Current price of underlying security
As the price of the underlying bond increases, the value of a call option
rises and the value of a put option falls
Strike price
Call (put) options become more (less) valuable as the exercise price
decreases
Time to expiration
For American options, the longer the time to expiration, the higher the
option price because all exercise opportunities open to the holder of the
short-life option are also open to the holder of the long-life option
Short-term risk-free interest rate
Price of call option on bond increases and price of put option on bond
decreases as short-term interest rate rises (through impact on bond price)
Expected volatility of yields (or prices)
As the expected volatility of yields over the life of the option increases, the
price of the option will also increase
Options on Bonds
Pricing
Options on long-term bonds
Interest payments are similar to dividends.
Otherwise, long-term bonds are like options on stock:
We can use Black-Scholes as in options on dividend-paying equity
Options on short-term bonds
They do not pay dividends
Problem: they are not like a stock because they quickly converge to par
We cannot directly apply Black-Scholes
Other shortcomings of standard option pricing
models
Assumption of a constant short-term rate is inappropriate for bond options
Assumption of a constant volatility is also inappropriate: as a bond moves
closer to maturity, its price volatility decline
Options on Bonds
Pricing
A solution to avoid the problem is to consider an
interest rate model, as described in Chapter 12
The following figure shows a tree for the 1-year rate of interest (calibrated
to the current TS)
The figure also shows the values for a discount bond (par = 100) at each
node in the tree
6%
6.5%
5.5%
6.5%
5.5%
7%
6%
5%
7%
6%
5%
7.5%
6.5%
5.5%
4.5%
7.5%
6.5%
5.5%
4.5%
83.97
88.2
89.8
93
94
95
100
100
100
100
83.97
88.2
89.8
88.2
89.8
93
94
95
93
94
95
100
100
100
100
100
100
100
100
Interest rates
Bond prices
Options on Bonds
Pricing
Consider a 2-year European call on this 3-year bond
struck at 93.5
Start by computing the value at the end of the tree
If by the end of the 2nd year the short-term rate has risen to 7% and the
bond is trading at 93, the option will expire worthless
If the bond is trading at 94 (corresponding to a short-term rate of 6%) the
call option is worth 0.5
If the bond is trading at 95 (short-term rate = 5%), the call is worth 1.5
Working our way backward the tree
( )
( )
( ) 5573 . 5 . 5 .
% 6 1
1
9479 . 5 . 1 5 . 5 . 5 .
% 5 . 5 1
1
2347 . 5 . 5 . 0 5 .
% 5 . 6 1
1
0
= +
+
=
= +
+
=
= +
+
=
d u
l
u
C C C
C
C
Options on Bonds
Put-Call Parity
Assumption no coupon payments and no premature exercise
Consider a portfolio where we purchase one zero coupon bond,
one put European option, and sell (write) one European call
option (same time to maturity T and the same strike price X)
Payoff at date T
B
T
< X:

You hold the bond: B
T

The call option is worthless: 0
The put option is worth: X - B
T

Thus, your net position is: X

B
T
X:

You hold the bond: B
T

The call option is worth: -(B
T
- X)
The put option is worthless: 0
Thus, your net position is: X
Options on Bonds
Put-Call Parity Cont
No matter what state of the world obtains at the
expiration date, the portfolio will be worth X
Thus, the payoff from the portfolio is risk-free, and
we can discount its value at the risk-free rate r
We obtain the call-put relationship
rT rT
Xe C B P Xe P C B

+ = = +
0 0 0 0 0 0
For coupon bonds
) (
0 0 0
Coupons PV Xe C B P
rT
+ =