Prolongation Right
Issuer Right to enhance the lifetime
The website provides an overview of embedded prolongation rights
What Is an Embedded Prolongation Right?
An embedded prolongation right (also referred to as an extension option) is an embedded derivative that gives either the issuer or the investor the right to extend the contractual maturity of a bond under predefined terms and conditions.
Instead of redeeming the bond at its original maturity date, the exercising party may choose to continue the bond for an additional period, typically with predefined coupon terms. The prolongation right is embedded in the bond contract and cannot be traded separately from the host debt instrument.
How Embedded Prolongation Rights Work
A prolongation right allows the maturity of the bond to be extended by:
- A fixed extension period (e.g. 3 or 5 years), or
- Multiple extension periods exercisable at specific dates
Key contractual elements typically include:
- Original maturity and extension dates
- Coupon rate during the extension period (fixed or floating)
- Notice periods and exercise conditions
At the original maturity date, the bondholder receives either:
- Repayment of notional (if no extension is exercised), or
- Continued coupon payments and deferred repayment (if the option is exercised)
Numerical Example: Prolongation Right
Assume a bond with the following terms:
- Notional: €1,000
- Original maturity: 5 years
- Coupon: 4% fixed
- Extension right: One-time extension of 3 years
- Extension coupon: 4% fixed
Scenario A: Market rates at maturity are higher
Market yield for similar risk: 6%
Redeeming and refinancing would be expensive for the issuer. Exercising the prolongation right allows the issuer to continue paying a below-market coupon. The issuer is likely to extend the bond.
Scenario B: Market rates at maturity are lower
Market yield for similar risk: 2%
Redeeming and refinancing would be cheaper. The issuer is likely to let the bond mature and repay the notional.
Key takeaway
The prolongation right has value because it allows the exercising party to choose the economically optimal outcome at maturity, depending on market conditions.
Accounting and Valuation
Embedded Conversion Rights Under IFRS 9
Under IFRS 9, embedded prolongation rights must be assessed to determine whether they are closely related to the host debt instrument.
Key considerations include:
- Whether the extension coupon reflects market rates
- Whether the extension significantly alters the bond’s economic profile
- Which party holds the option
If the prolongation right is not closely related:
- The embedded option must be bifurcated
- It is measured at fair value
- Fair value changes are recognized through profit or loss (P&L)
This makes prolongation rights particularly relevant for structured bonds and long-dated instruments.
Valuation of Embedded Conversion Rights
Valuing an embedded prolongation right requires modeling the economic benefit of extending the bond versus redeeming it at the original maturity.
Key valuation drivers include:
- Risk-free interest rate curves
- Credit spreads
- Coupon levels during the extension period
- Interest rate volatility
- Length and structure of extension periods
Interest Rate and Credit Spread Modeling
Valuation is typically performed using stochastic simulation, similar to callable or extendible bonds.
Common modeling approaches include:
- Hull–White one-factor models for risk-free interest rates
- CIR-type or diffusion models for credit spreads
For each simulated scenario:
- Market rates at the original maturity are projected
- The value of extending the bond is compared to redemption at par
- The optimal exercise decision is determined
- Cash flows are discounted using scenario-consistent curves
The fair value of the prolongation right is obtained as the expected value of the extension benefit.
Why Embedded Prolongation Rights Matter for Treasury and Accounting
Embedded prolongation rights:
- Affect bond duration and cash flow profiles
- Introduce optionality linked to interest rates and credit spreads
- Can create material P&L volatility under IFRS 9
- Require sophisticated valuation and documentation
For treasury and accounting teams, systematic identification and valuation of prolongation rights is essential for compliance and transparency.
Summary
Written by
Dominik KonoldFounder
Dominik is the founder of Finflexia and an expert in treasury accounting, financial instrument valuation and IFRS compliance. Since 2016, he's been a certified Professional Risk Manager (PRMIA) and also lectures for the Association of Public Banks and the Academy of International Accounting. He built Finflexia to help treasury teams automate complex accounting workflows.
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