Difference between bond with embedded call option vs callable bond everyone, regarding, different, difference

LiquidAssets10

Hi everyone,

i'm at the Fixed Income chapter, and see this:

Price of callable bond = Price of option-free bond - Price of embedded call option

Just confused regarding the difference between callable bond and bond with embedded call option.

Is embedded call option, a bond option? whereby it is an option to buy the bond?
Or is it a bond that has an option for the issuer to call back the bond? if it's the latter, how is it different from callable bond?

Jolyn

shootingstar

You are right that it is the right for the issuer to call back the bond. A callable bond is a bond with an embedded call option.

The reason for subtracting the price of the embedded call is because the advantage is to the issuer, therefore the investor has to be compensated for the the fact that he could potentially lose his expected return. The effect on price between a regular bond and a bond with embedded options is the movement in the option. Thus, the option is price is subtracted because the issuer can call back the bonds.