Embedded Redemption Option
Issuer Call Rights embedded in Bonds
The website provides an overview of embedded redemption rights relevant for treasury accounting purposes
What Is an Embedded Redemption Option?
An embedded redemption option (also referred to as an issuer call option) is an embedded derivative that gives the issuer of a bond the right to redeem the bond before its contractual maturity under predefined conditions. This right is embedded in the bond contract and cannot be traded separately from the host debt instrument.
Economically, a redemption option allows the issuer to respond to changing market conditions—most commonly to refinance the bond if interest rates or credit spreads decline. For investors, the redemption option limits upside potential and introduces reinvestment risk.
How Issuer Redemption Options Work
If an issuer exercises the redemption option, the bondholder receives:
- The outstanding notional amount, and
- An additional redemption amount, depending on the applicable redemption period
Redemption options are typically exercisable only during defined time windows and are often structured into multiple redemption phases, each with different economic outcomes.
Make-Whole Redemption Period
The make-whole period usually applies in the early years of a bond’s life. During this period, the issuer can redeem the bond at a price designed to fully compensate the investor for the loss of future coupon payments.
Key characteristics of make-whole redemption:
- The redemption price is calculated as the present value of remaining contractual cash flows
- Discounting is typically based on a reference government yield curve plus a fixed spread
- The economic intent is to make the investor “whole,” hence the name
In practice, the make-whole redemption amount is commonly defined as the maximum of two values:
- 101% of the notional amount, and
- The present value of the remaining contractual interest payments until the end of the make-whole period
The present value is typically calculated by discounting the future interest payments using a reference government yield curve plus a predefined credit spread, as specified in the bond documentation.
Formula (simplified):
Make-Whole Amount = max( 101% × Notional, Present Value of remaining interest payments )
This structure ensures that the investor receives at least a minimum premium (often 1%) while also protecting against the economic loss of forgone coupon income when interest rates have declined.
Because the make-whole amount closely reflects prevailing market conditions, make-whole redemption options are often considered closely related to the host debt instrument under IFRS 9, though this assessment depends on the specific contractual terms.
Fixed-Penalty Redemption Period
Following the make-whole period, many bonds enter a fixed-penalty redemption period. In this phase, the issuer may redeem the bond at:
- Par, or
- Par plus a predefined fixed premium (e.g. 102%, 101%, declining over time)
Key characteristics of fixed-penalty redemption:
- The redemption price is not market-based
- The issuer benefits more directly from favorable interest rate movements
- The economic value of the option increases when rates fall
Fixed-penalty redemption rights are more likely to be assessed as not closely related to the host contract and therefore more likely to require bifurcation as an embedded derivative.
Accounting and Valuation
Embedded Redemption Options Under IFRS 9
Under IFRS 9, embedded redemption options must be analyzed to determine whether they are closely related to the host debt instrument.
If the redemption option:
- Significantly alters the cash flow profile of the bond, and
- Is not aligned with market-based compensation
- then the option must be bifurcated and accounted for separately.
When bifurcation is required:
- The host bond is accounted for separately (e.g. at amortized cost)
- The embedded redemption option is measured at fair value
All changes in fair value are recognized through profit or loss (P&L)
This can introduce material P&L volatility and increases the complexity of valuation and reporting.
Modeling the Risk-Free Interest Rate Component
The risk-free interest rate curve is a key driver of the redemption decision, as declining rates increase the likelihood that the issuer will exercise the option to refinance.
A commonly used approach is the Hull–White one-factor model, which models the short rate as a mean-reverting stochastic process calibrated to the current risk-free yield curve and interest rate volatility.
Key characteristics:
- Mean-reverting behavior consistent with observed interest rate dynamics
- Ability to fit the initial yield curve exactly
- Widely accepted for valuation of callable bonds and interest rate derivatives
The Hull–White model is particularly suitable for simulating future discount factors used both in valuing the make-whole amount and in determining refinancing incentives.
Modeling the Credit Spread Component
In addition to the risk-free curve, the issuer’s credit spread plays a critical role in the valuation of redemption options. A tightening of credit spreads increases the economic benefit of early redemption and refinancing.
Standard Wiener Process (Diffusion Model): In this approach, credit spreads are modeled as a stochastic diffusion process driven by a standard Wiener process. This framework:
- Captures random spread movements over time
- Is straightforward to implement and calibrate
- Is suitable for short- to medium-term simulations
Cox–Ingersoll–Ross (CIR)–Type Credit Spread Models Alternatively, credit spreads may be modeled using a Cox–Ingersoll–Ross (CIR)–type process, which ensures that spreads remain non-negative. Key advantages:
- Mean-reverting behavior
- Positivity constraint for spreads
- Better stability in stressed market scenarios
The chosen credit spread model is typically calibrated to observable market data, such as bond spreads, CDS spreads, or issuer-specific curves.
Valuation of Embedded Redemption Options
The valuation of an embedded issuer redemption option depends on:
- Interest rate curves and forward rates
- Credit spreads
- Volatility assumptions
- Remaining maturity
- Structure of make-whole and fixed-penalty periods
Make-whole options are typically valued using discounted cash flow techniques, while fixed-penalty options often require option pricing approaches reflecting the issuer’s economic incentive to redeem.
Why Embedded Redemption Options Matter for Treasury and Accounting
Embedded redemption options:
- Affect fair value and earnings volatility
- Influence refinancing and funding strategies
- Require careful IFRS 9 assessment and documentation
- Demand accurate, market-consistent valuation
For treasury and accounting teams, automated identification, valuation, and reporting of embedded redemption options is essential for compliance, transparency, and audit readiness.
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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