- CFA Exams
- 2024 Level II
- Topic 6. Fixed Income
- Learning Module 42. Fixed-Income Securities: Defining Elements
- Subject 5. Bonds with Contingency Provisions
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Subject 5. Bonds with Contingency Provisions PDF Download
An embedded option is a provision in a bond indenture that gives the issuer and/or the bondholder an option to take some action against the other party. These options are embedded because they are an integral part of the bond structure. In contrast, "bare options" trade separately from any underlying security.
Embedded options may benefit either the issuer or the bondholder. An embedded option benefits the issuer if it gives the issuer a right or it puts an upper limit on the issuer's obligations. An embedded option benefits the bondholder if it gives the bondholder a right or it puts a lower limit on the bondholder's benefits.
A bond issue that permits the issuer to call or refund an issue prior to the stated maturity date is referred to as a callable bond.
A call option becomes more valuable to the bond issuer when interest rates fall. If interest rates fall, the issuer can retire the bond paying a high coupon rate, and replace it with lower coupon bonds. However, call provisions are detrimental to bondholders, since proceeds can only be reinvested at a lower interest rate.
Callable bonds exercise styles:
- American call: any time starting on the first call date
- European call: once on the call date
- Bermuda-style call: on predetermined dates following the call protection period
A put option grants the bondholder the right to sell the issue back to the issuer at a specified price ("put price") on designated dates. The repurchase price is set at the time of issue, and is usually par value.
Bondholders have the option of putting bonds back to the issuer either once during the lifetime of the bond (a "one-time put bond"), or on a number of different dates. The special advantages of put bonds mean that putable bonds have lower yield than otherwise similar bonds.
The price behaviour of a putable bond is the opposite of that of a callable bond. The put option becomes more valuable when interest rates rise.
A convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. This feature allows the bondholder to take advantage of favorable movements in the price of the issuer's common stock without having to participate in losses.
Suppose you can buy a 10%, 15-year, $100 par value bond today for $110 that can be converted into 10 shares at $10 per share. The market price of stock = $8; no dividends.
Warrants are securities entitling the holder to buy a proportionate amount of stocks at some specified future date at a specified price. They are similar to call options.
User Contributed Comments 6
|where'd everybody go, seems like about the 3rd readings the comments just drop away....
|to unregistered from the exam
|They are probably still in the FRA sections
|Conversion parity = value of the current stock after conversion = value of the bonds. Parity value or conversion value = value of stock after conversion
|when it says that the bond can be converted to stocks at 10 dollars does that mean that if the price of the stock rises above ten dollars, then you can convert?
I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.
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