callable bond is a real option #my take

If you are only working in the fixed income space, you may feel you don’t need option knowledge. Well, the ubiquitous callable bond is an embedded option. (Puttables are less ubiquitous.)

To the bond holder (or buyer), A long position in a callable bond is equivalent to
+ a long in a non-callable bond
+ a short position in a call option, which is like a giving out a shopping voucher “get a beer from me for $1”. If exercised, bond holder loses the “asset” — the long position in the regular bond

In other words, You buy a callable when you give counter party the right to “call it away”.
———-To the Issuer (not the dealer), a short position in a callable is equivalent to
+ a short position in a non-callable bond i.e. an obligation to pay fixed coupons + principal
+ a long position in a call option i.e. a right to pay holders a stipulated amount to acquire an “asset” that’s a perfect hedge for (100% cancels out) the short position.
Every call has an underlier asset. For a callable bond, the asset is the piece of paper representing ownership of a bond. The paper also has strips called coupons. When the issuer exercises the call, issuer pays par price to “buy” back the paper. Assuming there was only one holder for this issue, then issuer has no more liability. The bond ceases to exist.


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