Business and Personal Finance Dictionary

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• CALLABLE BOND
  
  Definition: A (noncallable) Bullet Bond (q.v.), minus (i.e., short) a Call Option (q.v.) on the bond. The Call Price as a function of calendar time is the Call Schedule. Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity. Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet. Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option. Risk Management: An issuer could offset the short position in the Bond Option (q.v.) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond. Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate.
  
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