Yield Measures: Option-Adjusted Yield
John's new bond has an embedded call option, making it possible that he won't get the 7.064% yield to maturity that he was planning on.
John calculated his yield to worst to be 6.857%, and is going with this conservative estimate for now, assuming that his four-year bond might be called in year three.
Another thing John might do is to just value the option itself. With an option model, John can look at the relevant inputs such as the distribution of interest rates, volatility measures, etc. and get a certain value for the bond, adjusting the flat price of the bond to an __option-adjusted price__.
How do you suppose the option-adjusted price will compare to the flat price, or option-free price, of John's bond?
No, this would be the case for an embedded put option, but consider which party to the bond contract benefits from the existence of an embedded call.
Absolutely!
The call option is an option for the issuer, and is therefore a bad thing for the investor. This option will reduce the value of the bond, meaning that the option-adjusted price is less than the flat price.
No, this is a good answer for a bond with an unspecified embedded option, but a call option works only in one direction.
Once John has calculated an estimate for the option-adjusted price (OAP), this price can be placed in the discounting equation to arrive at an __option-adjusted yield (OAY)__.
Since this bond has a 6% annual coupon and four years to maturity, John is now looking at this:
$$\displaystyle OAP = \frac{60}{(1+OAY)} + \frac{60}{(1+OAY)^2} + \frac{60}{(1+OAY)^3} + \frac{1,060}{(1+OAY)^4} $$
How do you think this option-adjusted yield will compare to the yield based on the flat price?
No, it should be higher.
Yes!
The option-adjusted price will be lower than the flat price, meaning that the yield based on this option-adjusted price will be larger than the yield based on the flat price.
How would you characterize this option-adjusted yield to John, if he were wondering how to view it?
To summarize this discussion:
[[summary]]
No, it's true that this yield will be higher than the yield calculated from the flat price, but the option exists. So any reasonable yield estimate will have to be higher. This doesn't make the yield optimistic, just more realistic.
No, actually there is no real chance of that John will get this yield. Remember that this is based on an option-adjusted price which came from a model, so it's an estimate central to many possible outcomes.
Excellent!
Yes, this is the expected yield accounting for the uncertainty surrounding that embedded option. It's not going to be the yield that John gets, and it's not conservative or optimistic. It's just a good estimate based on the distribution of possibilities.
The option-adjusted price will be greater than the flat price
The option-adjusted price will be less than than the flat price
The option-adjusted price will be less than or greater than the flat price
It should be higher
It should be lower
It's an expected yield of the bond, accounting for the embedded call
It's an optimistic estimate of the bond's yield, since it's always higher than the yield based on the flat price
It's the yield which John is most likely to realize by holding the bond until it is fully repaid
Continue
Continue
Continue
Continue
