An embedded option represents a right that can be exercised by the issuer, by the bondholder, or automatically depending on the course of interest rates. Embedded options can be:
A call option decreases the value of a bond to an investor. Therefore,
A put option increases the value of a bond to an investor. Therefore,
The value of any embedded option increases with interest rate volatility. The greater the interest rate volatility, the higher the chances for the embedded option to be exercised.
A call option is more likely to be exercised when interest rates fall. Hence, the value of an embedded call option is higher if the yield curve is downward sloping.
A put option is more likely to be exercised when interest rates rise. Hence, the value of an embedded put option is higher if the yield curve is upward sloping.
Sign up to get more!