Explanation

Correct Answer: B - A put if the issuer's rating changes.

Why Option B is Correct:

1. Embedded options granted to bondholders are rights that benefit the bondholder, not the issuer.
2. A put option gives bondholders the right to sell the bond back to the issuer at a predetermined price before maturity.
3. When triggered by a rating change, this put option protects bondholders from credit deterioration by allowing them to exit the investment.
4. This is a classic example of a bondholder-friendly embedded option.

Why Other Options are Incorrect:

Option A - A prepayment option:

• This is an issuer's option (call option) that benefits the issuer, not bondholders.
• Issuers can prepay bonds when interest rates fall, which harms bondholders who lose higher-yielding investments.

Option C - An increasing sinking fund provision:

• This is a mandatory redemption schedule that requires the issuer to retire a portion of the debt over time.
• While it provides some protection through regular principal repayment, it's not an "option" granted to bondholders.
• Sinking funds benefit bondholders by reducing credit risk, but they don't give bondholders discretionary rights.

Key Concepts:

• Embedded options for bondholders: Put options, conversion options (convertible bonds), extendible options
• Embedded options for issuers: Call options, prepayment options, acceleration options
• The distinction is crucial: bondholder options provide rights to the investor, while issuer options provide rights to the borrower.