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The nearby box describes a newly designed bond with returns linked to the performance
of Internet stocks. It should be clear from the description of the so-called “equity linked
note” that the security is in fact a collar on an Internet stock index. Indeed, in the last para-
graph of the article, one observer notes that the security would appeal only to retail in-
vestors since larger institutional investors can already engineer the bond for themselves
using calls and puts.

4. Graph the payoff diagram for the collar described in Example 14.5.
Suppose you never intend to trade an option directly. Why do you need to appreciate the prop-
erties of options in formulating an investment plan? Many financial instruments and agree-
ments have features that convey implicit or explicit options to one or more parties. If you are to
value and use these securities correctly, you must understand these embedded option attributes.

Callable Bonds
You know from Chapter 9 that many corporate bonds are issued with call provisions entitling the
issuer to buy bonds back from bondholders at some time in the future at a specified call price. A
call provision conveys a call option to the issuer, where the exercise price is equal to the price at
which the bond can be repurchased. A callable bond arrangement is essentially a sale of a
straight bond (a bond with no option features such as callability or convertibility) to the investor
and the concurrent sale of a call option by the investor to the bond-issuing firm.

The CBOE regularly publishes strategies that show how options can be used. Go to
http://www.cboe.com/common/ autoindexpages.asp?DIR=LCWeeklyStrat&HEAD=Weekly
%20Strategy%20Discussion&BYEAR=true &SEC=6 for an archive of published strategies.
From this listing of strategies, select the collar strategy published on April 29, 2002.
After reviewing the collar strategy, explain how it works and the benefits of using the
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

Bond Offers the Internet sans Anxiety
Internet stocks surge. The bonds, which provide no in-
Want to invest in Internet stocks but don™t have the
terest payments, are callable during a 30-day period
stomach for the risk? Wall Street has concocted a prod-
each year after three years, but investors would get an
uct made just for you.
annual premium of 25% of their original investment.
Proving that securities firms never miss an opportu-
The obvious attraction of the securities: They allow
nity to jump on an investment craze, Salomon Smith
investors to reap the rewards of the Internet without risk-
Barney, a unit of Citigroup Inc., yesterday unveiled the
ing losing their shirt. The securities also provide some
first bond linked to a basket of Internet stocks.
diversification within the volatile sector without forcing
Basically, it is an Internet play for wimps: The down-
an investor to recreate the 20-stock index himself.
side risk is limited to a loss of 10% of the original in-
There are dangers in the bonds, however, despite
vestment, no matter how much Internet stocks tumble
their conservative nature. While investors can only lose
during the seven-year life of the bonds. But if the index
10% of their initial outlay, a $10 investment in a risk-
soars higher and the bonds are called, the upside
free instrument such as Treasury securities, at today™s
would also be limited, to 25% a year.
rates, would return about $14.60 after seven years.
Despite the Internet sector™s weakness, $65 million
Investment bankers at other Wall Street firms said
of the newfangled securities were sold, mostly to indi-
they are intrigued by the Salomon product and might
vidual investors.
pursue something similar aimed at individual investors.
Termed “callable equity linked notes,” the securities™
But some analysts doubt they will prove popular with
return is pegged to the performance of TheStreet.com
larger investors. According to Steve Seefeld, president
Internet Index of 20 stocks.
of ConvertBond.com, “An institution can just buy the
At maturity, Salomon will repay the $10 principal
stocks in index and recreate the securities using shares,
per note plus or minus an amount linked to the in-
puts and calls,” Mr. Seefeld says.
crease or decrease in the value of the Internet index,
with a minimum payout of $9 no matter how far the in-
SOURCE: Gregory Zuckerman, “Bond Offers the Internet sans
dex drops. The maximum would be $25 per $10 note
Anxiety,” The Wall Street Journal, May 26, 1999. Reprinted by
(the 25% maximum annual increase wouldn™t be com- permission of Dow Jones & Company, Inc. via Copyright Clearance
pounded), for a total return of 150% if the bonds are Center, Inc. © 1999 Dow Jones & Company, Inc. All Rights Reserved
called after the sixth year, as they would likely be if Worldwide.

There must be some compensation for offering this implicit call option to the firm. If the
callable bond were issued with the same coupon rate as a straight bond, we would expect it to
sell at a discount to the straight bond equal to the value of the call. To sell callable bonds at
par, firms must issue them with coupon rates higher than the coupons on straight debt. The
higher coupons are the investor™s compensation for the call option retained by the issuer.
Coupon rates usually are selected so that the newly issued bond will sell at par value.
Figure 14.12 illustrates this optionlike property. The horizontal axis is the value of a
straight bond with otherwise identical terms as the callable bond. The dashed 45-degree line
represents the value of straight debt. The solid line is the value of the callable bond, and the
dotted line is the value of the call option retained by the firm. A callable bond™s potential for
capital gains is limited by the firm™s option to repurchase at the call price.

5. How is a callable bond similar to a covered call strategy on a straight bond? Concept
The option inherent in callable bonds actually is more complex than an ordinary call option CHECK
because usually it may be exercised only after some initial period of call protection. The price
at which the bond is callable may change over time also. Unlike exchange-listed options, these
features are defined in the initial bond covenants and will depend on the needs of the issuing
firm and its perception of the market™s tastes.
< Concept
6. Suppose the period of call protection is extended. How will this affect the coupon
rate the company needs to offer to enable it to sell the bonds at par value?
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

514 Part FIVE Derivative Markets

F I G U R E 14.12
Values of callable
Value of straight debt
bonds compared with
straight bonds
Value of callable bond

Value of firm™s
call option

Value of
straight debt
Call price

Convertible Securities
Convertible bonds and convertible preferred stock convey options to the holder of the security
rather than to the issuing firm. A convertible security typically gives its holder the right to ex-
change each bond or share of preferred stock for a fixed number of shares of common stock,
regardless of the market prices of the securities at the time.

7. Should a convertible bond issued at par value have a higher or lower coupon rate
than a nonconvertible bond at par?
For example, a bond with a conversion ratio of 10 allows its holder to convert one bond of
par value $1,000 into 10 shares of common stock. Alternatively, we say the conversion price
in this case is $100: To receive 10 shares of stock, the investor sacrifices bonds with face value
$1,000 or $100 of face value per share. If the present value of the bond™s scheduled payments
is less than 10 times the value of one share of stock, it may pay to convert; that is, the conver-
sion option is in the money. A bond worth $950 with a conversion ratio of 10 could be con-
verted profitably if the stock were selling above $95, as the value of the 10 shares received for
each bond surrendered would exceed $950. Most convertible bonds are issued “deep out of the
money.” That is, the issuer sets the conversion ratio so that conversion will not be profitable
unless there is a substantial increase in stock prices and/or decrease in bond prices from the
time of issue.
A bond™s conversion value equals the value it would have if you converted it into stock
immediately. Clearly, a bond must sell for at least its conversion value. If it did not, you could
purchase the bond, convert it immediately, and clear a riskless profit. This condition could
never persist, for all investors would pursue such a strategy and quickly bid up the price of
the bond.
The straight bond value or “bond floor” is the value the bond would have if it were not con-
vertible into stock. The bond must sell for more than its straight bond value because a con-
vertible bond has more value; it is in fact a straight bond plus a valuable call option. Therefore,
the convertible bond has two lower bounds on its market price: the conversion value and the
straight bond value.
Figure 14.13 illustrates the optionlike properties of the convertible bond. Figure 14.13A
shows the value of the straight debt as a function of the stock price of the issuing firm.
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

14 Options Markets

F I G U R E 14.13
Value of a convertible
bond as a function of
stock price


Stock price
Straight debt value



Stock price
Conversion value

Convertible bond value
Conversion value
Straight debt value

Stock price
Convertible bond value

For healthy firms, the straight debt value is almost independent of the value of the stock be-
cause default risk is small. However, if the firm is close to bankruptcy (stock prices are
low), default risk increases, and the straight bond value falls. Panel B shows the conversion
value of the bond. Panel C compares the value of the convertible bond to these two lower
When stock prices are low, the straight bond value is the effective lower bound, and the
conversion option is nearly irrelevant. The convertible will trade like straight debt. When
stock prices are high, the bond™s price is determined by its conversion value. With conversion
all but guaranteed, the bond is essentially equity in disguise.
We can illustrate with two examples.
Bodie’Kane’Marcus: V. Derivative Markets 14. Options Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition


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