Prepayments option

The two most common types of embedded options are call (or prepay) options and put options. As interest rates in the market decline, the issuer may call or prepay the debt obligation prior to the scheduled principal repayment date. The other type of option is a put option. This option gives the investor the right to require the issuer to purchase the bond at a specified price. Below we will examine the price/yield relationship for bonds with both types of embedded options (calls and puts) and implications for price volatility. 

The prepayment option of the holders of mortgages underlying a mortgage security is essentially a call option. Not surprisingly, then, mortgage securities often behave like callable bonds. 

As noted, a bond may contain an embedded option which permits the issuer to call or retire all or part of the issue before the maturity date. The bondholder, in effect, is the writer of the call option. From the bondholder s perspective, there are three disadvantages of the embedded call option. First, relative to bond that is option-free, the call option introduces uncertainty into the cash flow pattern. Second, since the issuer is more likely to call the bond when interest rates have fallen, if the bond is called, then the bondholder must reinvest the proceeds received at the lower interest rates. Third, a callable bond s upside potential is reduced because the bond price will not rise above the price at which the issuer can call the bond. Collectively, these three disadvantages are referred to as call risk. MBS and ABS that are securitized by loans where the borrower has the option to prepay are exposed to similar risks. This is called prepayment risk, which is discussed in Chapter 11. 

In the discussion below, we will refer to a bond that may be called or is prepayable as a callable bond. Exhibit 4.16 shows the price/yield relationship for an option-free bond and a callable bond. The convex curve given by a-a" is the price/yield relationship for an option-free bond. The unusual shaped curve denoted by a-b in the exhibit is the price/yield relationship for the callable bond. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

The optionality of a mortgage-backed bond, and the volatility of its yield, frequently have a negative impact on the bondholders. This is for two reasons the actual yield realized during the holding period has a high probability of being lower than the anticipated yield, which was calculated on the basis of an assumed prepayment level, and mortgages are frequently prepaid when the bondholders will suffer the most—that... 

Because OAS analysis takes into account a mortgage-backed bond s option feature, it is less affected by a change in interest rates or the yield curve, which affect prepayments, than the bond s yield spread. Assuming a flat yield curve, the relationship between the OAS and the yield spread is expressed in equation (14.18). 

This relationship can be observed when yield spreads on current-coupon mortgages widen during declines in interest rates. As the possibility of prepayment increases, the cost of the bonds option feature rises put another way, the option feature gets closer to being in the money. To adjust for the increased value of the option, traders price higher spreads into the bond, which keeps the OAS more or less unchanged. 

Thus the OAS is an indication of the value of the option element of the hond as well as the premium required by investors in return for accepting the default risk of the corporate bond. When OAS is measured as a spread between two bonds of similar default risk, the yield difference between the bonds reflects the value of the option element only. This is rare and the market convention is measure OAS over the equivalent benchmark government bond. OAS is used in the analysis of corporate bonds that incorporate call or put provisions, as well as mortgage-backed securities with prepayment risk. For both applications, the spread is calculated as the number of basis points over the yield of the government bond that would equate the price of both bonds. 

The absolute prepayment speed (ABS) is a standard measure for prepayments, comparing actual period prepayments as a proportion to the whole pool balance. As with all prepayment metrics, this measure provides an indication of the expected maturity of the issued ABS and, essentially, the value of the call option on the issued ABS at any time. 

Chen, S. 1996. Understanding Option-Adjusted Spreads The Implied Prepayment Wy ot es s. Journal of Portfolio Management, Summer, 104—113. 

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