Callable Bond
Overview
A callable bond is a bond that can be "called" by the issuer of the bond prior to the bonds stated
maturity. This means that the issuer of the bond can at any time decide to pay off the bond by
paying the full principal, in which case, the bond is considered mature and no further interest payments
need to be made.
Callable bonds are typically called if interest rates go down. In such a case, a company can call the bond,
and issue new bonds at the new lower rate.
The option to call a bond requires a premium be paid by the issuer of the bond.
Valuing the Embedded Option
Issuers of callable bonds must pay a premium over and above the price of the bond from just
present value
considerations. The call option is a
derivative,
and models developed to price the option follow the standard derivative pricing techniques.
