Embedded Options

Value bonds with embedded options properly: build a Black–Derman–Toy or Ho–Lee rate tree calibrated to the Treasury curve, exercise calls and puts on coupon dates or hold a floater's coupon between its cap and floor, and get each option's value, the option-adjusted spread, and effective duration and convexity. Convertible bonds are valued on a share price tree.

Learning focus: callable = straight bond − call option, capped floater = floater − cap, convertible = straight bond + an option on the shares.