This might be a simple one, but can’t think straight. Help appreciated!!
In one of the Elan videos, the following question is discussed:
Which of the following is least likely an option that favours the issuer of a security:
(a) call provision
(b) prepayment option
© floor
I would have thought (b) and ©, but the solution is only ©
How is that.
Let’s say the floor is 2%, but prevailing interest rates is at 1%. Since the company guaranteed a floor and thus must pay 2%, they have to pay 1% above markets rates - to the issuer detriment.
+1
A prepayment option favors the issuer: they’re allowed to pay the bond off early (e.g., when interest rates are low) if they want to, but they don’t have to. It’s very similar to a call option.
The issuer would use the prepayment option in a rising interest rate environment. It would prepay bonds with higher interest rates and reissue at lower interest rates. As S2000magician mentioned, it is nearly identical to a call provision.
In a _ falling _ interest rate environment, you mean.
(If interest rates were rising, they would be higher for the new issue, not lower.)
Right, sorry.