Callable bonds
Sorry for having 2 posts in a row. But I think the following may be useful to classmates doing finance-related stuff. =) A little something I was discussing with XY~ Just for your information when you need it.
A callable bond is a bond which the borrower (issuer) has an option to redeem prior to its maturity date.
The investor should assume that the borrower will exercise the option to the disadvantage of the investor.
Given that the redemption value on all redemption dates are equal (note that we're taking an assumption here):
1) If i less than g or P greater than C, redemption date will be the earliest possible date.
2) If i greater than g or P less than C, redemption date will be the latest possible date.
(zzz damn irritating... somehow the greater than/ less than signs are rejected by blogger due to conflict with html code... zzz... !@#$%^&*)
If the redemption values on all the redemption dates including the maturity date are not equal, then it may be necessary to take some trial calculations at the various possible redemption dates to see which is the most unfavourable to the investor.
Some actuarial symbols here:
i = yield rate, yield to maturity, yield to redemption
g = modified coupon rate where Fr = Cg (F = nominal value, par value, face value; r = coupon rate, nominal yield; C = redemption value. Here, please also note that F != C)
P = price of the bond
C = (as mentioned above)
Earliest possible date here isn't disputable, and should be specified by the bond issued.
And here, the reason why I emphasized that the "investor should assume that the borrower will exercise the option to the disadvantage of the investor" is because the investor is the passive party. Pay special attention that the issuer is the one who would finally decide when to redeem the bond and it may not be the "earliest possible date". Therefore, as a third party, when we analyse such cases, we should take special consideration to the risk the passive party faces.
Hope this helps! =)
