Give the issuer or bondholder rights to dispose of or redeem a bond and can have a dramatic effect on the price of a security’s cash flow as well as its total return.
Options that Benefit the Issuer
Call options - allows the issuer to call the bonds prior to maturity if prevailing rates decrease enough to replace the existing issue with lower coupon bonds.
Prepayments - similar to call features and gives the issuer the right to repay principal ahead of scheduled repayment, in whole or in part.
Caps – A cap puts a maximum amount that an issuer has to pay in the face of rising interest rates for bond with floating interest rate.
Options that Benefit the Holder
Puts - give the bond bolder the right to receive principal repayment before maturity and help them dump their holdings and reinvest their proceeds at a higher rate as rates rise.
Floor - set a limit on the interest payment at a certain level even as market rates decline below the floor level.
Conversion option - give the right to bondholder to exchange for the issuer’s stock when the equity of the firm is outperforming the bonds.
Notes:
· If the option benefit the issuer, the yield increase.
· If the option benefit the bondhodler, the yield decrease.
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