Callable Bond Research Paper

1. Introduction

An embedded option is an option to buy or sell a bond at a certain price before its maturity date [1]. Options are often embedded in bonds when they are issued to make them more appealing to the issuer or to future investors.

In this project, we focus on bonds with an embedded call option, known as callable bonds.

Issuers are in general interested in contracts with such an embedded option because it allows them to redeem the bond when the conditions of the financial market are in their favour.

Therefore, the call option is mainly beneficial for the issuer, that’s why it’s less expensive than a bond without a call feature [2].

The standard approach to price callable bonds was based on interest rate dynamics. For example a trinomial tree using the

For example, the interest rate has an impact on embedded options.When interest rates increase, the price of the call option declines, and as a result the price of callable bond rises.

There are other factors that affect the price of the bond such as expected volatility, etc.

We can distinguish three types of callable bonds on the market, depending on the type of the call option: American, European or Bermudan [5].

● American call: the bond can be redeemed at any time before the maturity date. There is also the Semi-american Call, a particular case, where the issuer has to give a two-months prior notice before redeeming the bond.

● European call: the bond can only be redeemed at a specific date which is specified in the contract.

● Bermudan call: Bermudan Call can be seen as an intermediate option between the

European and the American Call. In the case of the Bermudan Call, the issuer can redeem the bond on predetermined schedule of dates, fixed in the contract, after the lockout period.

To sum up a callable bond can be defined by the following elements:

● principal

● zero coupon rate

● issued