Financial instruments containing options have become generally accepted in the market place. These instruments are available as investment securities for institutions to buy and credit products that institutions can use to fund their balance sheets. The type of option contained within these products affects the yield on the investment or the cost of the funding vehicle. This article describes some of the different types of options contained in some familiar investment and credit products

Many government-sponsored enterprises, including the Federal Home Loan Banks, issue instruments with various types of options embedded. The most familiar investment securities are callable bonds. They allow the buyer to receive an enhanced yield in return for allowing the issuer the opportunity to call or terminate the issue. The termination typically occurs when rates fall and the issuer can refinance at a lower rate.

It is important to understand the nature of the option that is contained within the financial instrument. A callable bond may be issued with one of a variety of call options. The type affects the yield and the duration of the instrument.

The three most common types of options are the European option, the American option, and the Bermuda option, the latter being a hybrid of the first two. The three types of options are displayed on the map below. The flexibility of the different types can be depicted geographically, with the American option having the most flexibility and the European the least.

The European option is the most basic. It allows the issuer to cancel the bond on one specific date during the lifetime of the investment. The American option allows the issuer to cancel the bond at any time after a specified date.

The Bermuda option, which is sometimes referred to as a Modified American option, allows the issuer to call the bond at discrete points in time after a certain date. Because it can be cancelled on multiple dates, it behaves more like an American option than a European option. This resulted in the name Bermuda option, because Bermuda is closer geographically to America than to Europe.

The market is fairly efficient in exercising both the Bermuda and European options on callable bonds. Occasionally a bond with a Bermuda option will have a market value that indicates that the bond should be called, and the bond is not called. This occurs because the issuer hedges many of these structures with swaps, and the swap drives many of the call decisions. The American options have a more unpredictable call schedule because they may be exercised at any time after the lockout. The exact date of the exercise is hard to predict, and other subjective influences of the issuer may affect when the call is exercised.

Below is a table that depicts some of the differences between a five-year bullet agency bond and a typical new issue five-year non-call one-year bond containing the different types of options. The yield the investor receives is different. The agency note without an option is very attractive relative to the Treasury, but when the options are included the yield is improved even more. The one-time European option provides a yield forty-six basis points greater than the bullet. The American option provides the most yield as it contains the most flexibility to the issuer. The Bermuda option provides slightly less yield than the American option, but it has a more predictable exercise schedule.

The FHLBI offers advance products with embedded options. The member can borrow a callable advance, which allows the member to cancel the advance, or a putable advance, which allows the FHLBI to convert the advance. The rate on a callable advance is higher than the rate on a fixed rate bullet advance because the member owns the right to cancel the advance. The rate on a putable advance is lower than a fixed rate bullet advance because the FHLBI owns the right to terminate the advance.

The most popular product over the past two years has been the putable advance. We have expanded the variety of options available to members to include putables with both European and Bermuda options. These products have different characteristics because of the type of option embedded. In most interest rate environments the European option has a higher probability of converting than a Bermuda option. At the time of conversion the rate on the European putable should be compared to a bullet advance with the same remaining term. The rate on the Bermuda advance is compared to the rate on a putable with the same remaining term, but with options that can be exercised every three months. If the rate on the putable is lower than current market rates, it will most likely convert.

The FHLBI introduced a variation to the putable advance last September. This is a putable with an option that is exercised if three-month LIBOR is equal to or greater than a predetermined strike level. These options are sometimes referred to by the FHLBI as LIBOR-indexed options. The level of LIBOR drives the exercise on these structures on a given date. For this reason this putable structure is fairly easy to understand and the borrower can predict whether the option is in the money or out of the money.

The LIBOR-indexed putable behaves differently than a putable with a traditional Bermuda or European option. The option exercise is a function of a money market index; therefore, the shorter end of the yield curve has a greater influence on whether the option is exercised. Some events that may affect this structure more than a regular putable are quarter-end and year-end overnight rate expectations. For example, as the end of 1999 approached the market observed an increase of over fifty basis points in three-month LIBOR from Sept. 28 to Sept. 29.

We currently do not offer putable advances with American options because there would not be any additional savings to the member. There would also be a less predictable conversion schedule for the member to keep track of.

One of the most popular putable structures this year is the ten-year putable with a one-year lockout. The table below compares the pricing on ten-year nonput one-year advances with the different putable options to one- and ten-year bullet advances.

As part of the FHLBI's efforts to assist members in the analysis of putable credit products, month-end market values on outstanding putable advances will be provided on FHLBI's Member Link website beginning this summer. These will be located in the credit account inquiry section on the secured, member-only portion of the website.

In addition the FHLBI will provide pre-purchase analytics on a selection of putable structures. The information includes dollar sensitivities in different rate environments for advances with the different types of options. There will be a separate section for Bermuda options, European options, and LIBOR-indexed options. The analytics will provide an estimate of the sensitivity of the advance at the time of commitment. As time erodes and the market environment changes these sensitivities will also change. The pre-purchase analytics will be located in the rate options section of Member Link.

It is important for the investor/borrower to understand the option that is contained within the financial instrument they are considering. This will allow the instrument to be properly evaluated relative to other alternatives.