When bond issuers, such as corporations, issue bonds, one of the risks they face is the interest rate risk. When interest rates decrease, bond prices increase. While existing bondholders will find their bonds more valuable, bond issuers, on the other hand, find themselves in a losing position since they will be issuing higher interest payments than the prevailing interest rate. Conversely, when interest rates increase, bond issuers are at an advantage since they are able to continue issuing the same low interest payments as agreed on the bond contract specifications.

To capitalize on interest rate changes, bond issuers may embed options within a bond. This allows the issuer the right, but not the obligation, to buy or sell the issued bond at a predetermined price during a specified period of time. An American type of bond option allows the issuer to exercise the rights of the option at any point of time during the lifetime of a bond. An European type of bond option allows the...