Print Callable Securities - An Introduction A callable municipal, corporate, federal agency or government security gives the issuer of the bond the right to redeem it at predetermined prices at specified times prior to maturity. Take, for example, a U.
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In an example fromA U. The difference in dollar price between these two securities would represent the value of the call option.
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- Embedded Option Definition
The investor has to determine the value of the option and the level of compensation required for the associated risks in a callable security. American options are continuously callable at any time after the lockout period expires. Bermudian options give the issuer the right to call the bond on specified dates after the lockout period that typically coincide with coupon dates. European options deposit with embedded option a one-time call feature coinciding with the expiration of the lockout period.
Callable Securities - An Introduction
For example, the embedded option in a year noncallable for six months 10nc6M can be likened to a 6-month European option on a 9. The embedded option in a 10nc3 European callable is the same as a 3-year option on a 7-year security.
The uncertainty or risk associated with 7-year rates three years from now is higher than the uncertainty of 9. Discount callables trade like bullets—non-callable bonds—to maturity and carry compression risk. If interest rates fall, they become more likely to be called.
Callable securities that are at the money—where interest rates are very close to the point where the option will be exercised—have the most sensitivity to changes in market rates and implied volatility. The first is realized volatility: large swings in rates can necessitate frequent rehedging, with its associated costs, as well as underperformance. Implied volatility, or the market forecast of future rate uncertainty, is the second.
When a position is unwound or sold, the value of the callable security will depend on the new level of implied volatility. If implied volatility is higher, callable security prices will be depressed.
Investment Strategies Using Callable Securities Many investors use callable securities within a total return strategy—with a focus on capital gains as well as income—as opposed to a buy and hold strategy focused on income and preservation of principal. Owners of callable securities are expressing the implicit view that yields will remain relatively stable, enabling the investor to capture the yield spread over noncallable securities of similar duration.
If an investor has the view that deposit with embedded option may well be volatile in either direction over the near term but are likely to remain in a definable range over the next year, an investment in callable securities can significantly enhance returns. Premium callables would generally be used when the bullish investor believes that rates are unlikely to fall very far.
Discount callables would generally be chosen when the investor believes volatility will be low but prefers more protection in an environment of rising interest rates. The yield curve is the collection of interest rates at a variety of maturities.
CFA L2 FY SS 14 Reading 45 Valuation of Bonds with embedded options Part 1
In most cases, the longer the maturity on a bond, the higher its yield. A steeply sloped yield curve indicates a relatively big difference between yields on bonds with shorter and longer maturities. Yield spreads in this deposit with embedded option refers to the difference between the interest rates of bonds of two different maturities, or two points on the yield curve.