I have a doubt on the calculation of prices of bonds with embedded options using binomial trees… Let’s suppose that I have a putable bond which can be exercised at the end of say the 2nd and 3rd year… Is it necessary that the option needs to be exercised on those dates where it can be exercised or can the holder of the bond choose to optimally exercise the option on a particular date instead of all dates where it can be exercised (exercising the option when I can expect a higher pay-off later on)?? If the option can be optimally exercised, won’t the value of the option and hence the option-embedded bond be different??
The assumption that CFA Institute uses is that the option is exercised anytime it is in the money. That has the advantage of being easy and objective, but may not match market behavior. However, it’s perfectly satisfactory for teaching the theory of how binomial trees work.
Thanks a lot for clearing the doubt… As such why are option embedded bonds treated as exercisable everywhere (where it is in the money) by CFA Institute??
I believe the answer is in S2000’s post, it’s easy and objective. Without a computer to assist in answering, I’m not sure how you could model the embedded option questions otherwise.
