Put and call options are derivative investments, and their price movements are based on the price movements of another financial product, often called the underlying. A call option is bought if the trader expects the price of the underlying to rise within a certain time frame. A put option is bought if the trader expects the price of the underlying to fall within a certain time frame. Puts and calls can also be written/sold, which generates income but gives up certain rights to the buyer of the option.
Bond investors can seek a shield via ‘put option’, an integral part of many bond sale agreements, which provides an exit route. Investors consider this option a safety net, though it may fire back as well. Bonds with a put option are referred to as put bonds or putable bonds. This is the opposite of a call option provision. The exact terms and details of the provision are discussed in the bond indenture.
A put option is used by investors who may want to move out of their bond investments. So, if the borrowers offer put or call options or both at the time of bond sale, then it adds to investor confidence. So, with the put option, investors know they now have the option to move out of their bond investments if they want to at a future date. The call option, on the other hand, is exercised by the borrowers: they can use it to finish off the debt they owe midway without servicing the full tenor.
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Need for put and call options
An investor can exercise put option for reasons, such as, immediate cash requirement, a changing interest rate scenario or a rating change that might hit future repayments. Investors are nervous amid the crisis in the non-banking finance sector. Para banks are running short of money as they face a mismatch between short liabilities and long-term assets. Moreover, a sudden fall in ratings makes it a regulatory challenge for the select group of institutional investors, which are not allowed to hold debt securities beyond stipulated rating grades.
A bond series that has 10-year maturity has 5-year put options, that is, investors can surrender investments after 5 years seeking immediate redempltion; borrowers are to repay them proportionate to the 5-year investment horizon.
An Example
In June 2019, SinTex Industries, a manufacturer of textile and yarns, which is based in Ahmedabad, defaulted about ` 90 crore repayments on bonds. Investors are likely to have exercised option for which the company did not have money to repay. Investors are likely to use this option if they feel the borrower may not be able to rupay them.
Are the options risky?
Yes. If a company is on the verge of arranging money to repay all its pending dues and investors suddenly exercise such an (put) option, it will only draw a blank. However, on the other hand, if a company has some residual money, it may be forced to repay immediately instead of dragging it amid tough time.