Explanation

Correct Answer: B

In the arbitrage-free valuation framework:

Value of option-embedded bond = Value of option-free bond + Value of embedded options

This relationship holds because:

• The option-embedded bond can be decomposed into its component parts
• The option-free bond represents the base bond without any optionality
• The embedded options (calls, puts, etc.) have their own separate values
• The sum of these components equals the total value of the bond with embedded options

Why this is important:

• This decomposition allows for proper valuation of complex bonds
• It ensures no arbitrage opportunities exist in the market
• Each component is valued using appropriate discount rates and models