Debt securities and bonds provide some options which benefit the issuers and the loan borrowers. These options are
Call options is same as derivative options which provides the issuer the right (but not the obligation) to call back or retire the debt securities or bond issue as a whole or just some part of it before the maturity date. This option is enabled only for callable bonds and this is decided at the time of issuing the bond in the market along with the call price. If the bond or debt securities are called then the bond investors have to surrender or sell the bonds at call price.
The callable option can be used only after some period which is called the call protection period to protect the bondholders. After the call protection period, the bond issuer can call back the bonds at any point of time at the call price. As it gives additional benefits to the bond issuer, the bondholders need discount to subscribe in these bonds. That’s why the callable bonds are sold at much below price than the normal bonds.
Value of a callable Bond = Value of an option free bond – Value of the call option
Bond issuers normally use this call option to replace the higher coupon bonds with the lower coupon bonds when the market interest rate is lower.
Prepayment option is used by the loan borrowers for the loans backed by securities or assets such as mortgage or car loans. It provides the loan borrower the right to prepay some part or the entire principal amount before the maturity date without any penalty. Loan borrowers use this option to replace an existing mortgage loan with another one at much lower interest rate which benefits them in the long run with lower interest payment.
Cap Coupon payment
For floating rate bonds, the coupon rate is determined based on some other floating reference rate like LIBOR (London Inter-Bank Offered Rate). The Cap coupon option sets the maximum amount for coupon payment even if the reference rate goes higher than that. It protects the bond issuer from coupon rate going beyond their credibility limit.