The expected yield to maturity (YTM) of a bond/ note that is adjusted for an embedded option (e.g., an issuer’s call provision). The option’s impact is probability weighted (as expressed in the option-adjusted price), and is added to the flat price of the bond/ note. The embedded call option reduces the value of the bond/ note (for its holder). In other words, the holder pays less what otherwise would have been paid for an option-free bond.
The option-adjusted yield represents the required market discount rate after adjusting for the embedded option. The value of the embedded option is the price of the option-free bond minus the price of a callable bond. This yield measure is less than or equal to the yield-to-maturity because callable bonds produce higher yields to compensate their holders for the issuer’s call option.
The option-adjusted yield can be used as a basis for comparison of the yields of bonds that come with different embedded options.
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