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Global Edition: Analysis of Bonds With Embedded Options
Global Edition: Analysis of Bonds With Embedded Options
Global Edition: Analysis of Bonds With Embedded Options
Chapter 17
Analysis of Bonds
with Embedded
Options
Learning Objectives
Treasury Spot
Period Cash Flow 100 BP 110 BP 120 BP
Rate (%)
Yield to
Bond Price Maturity (%) Traditional Static Difference
25-year 8.8% Coupon Bond
Treasury 96.6133 9.15 — — —
A 88.5473 10.06 91 100 9
B 87.8031 10.15 100 110 10
C 87.0798 10.24 109 120 11
…. …. …. …. …. ….
5-year 8.8% Coupon Bond
Treasury 105.9555 7.36 — — —
J 101.7919 8.35 99 100 1
K 101.3867 8.45 109 110 1
L 100.9836 8.55 119 120 1
aAssumes Treasury spot rate curve given in Exhibit 17-1.
Price
a’
Noncallable Bond
a’- a
b
Callable
Bond
a-b a
y* Yield
a’
PNCB
Noncallable Bond
PCB a’- a
b
Callable
Bond
a-b a
y** y* Yield
❖ The bond valuation process requires that we use the theoretical spot
rate to discount cash flows.
❖ This is equivalent to discounting at a series of forward rates.
❖ For an embedded option the valuation process also requires that we
take into consideration how interest-rate volatility affects the value
of a bond through its effects on the embedded options.
Maturity Y i e ld t o Market
Years M a t u r i t y (%) Value
1 3.50 100
2 4.00 100
3 4.50 100
Spot O ne – Y e a r
Years R a t e (%) F or w a r d R a t e
1 3.500 3.500
2 4.010 4.523
3 4.541 5.580
❖ Interest-Rate Model
o As explained in the previous chapter, an interest-rate model is
a probabilistic description of how interest rates can change
over the life of a financial instrument being evaluated.
o An interest-rate model does this by making an assumption
about the relationship between the level of short-term interest
rates and interest-rate volatility (e.g., standard deviation of
interest rates).
o The interest-rate models commonly used are arbitrage-free
models based on how short-term interest rates can evolve
(i.e., change) over time.
o The interest-rate models based solely on movements in the
short-term interest rate are referred to as one-factor models.
o More complex models would consider how more than one
interest rate changes over time.
❖ Interest-Rate Lattice
o Exhibit 17-7 (see Overhead 17-28) shows an example
of the most basic type of interest-rate lattice or tree, a
binomial interest-rate tree. The corresponding model is
referred to as the binomial model.
o In this model, it is assumed that interest rates can
realize one of two possible rates in the next period. In
the valuation model we present in this chapter, we will
use the binomial model.
o Valuation models that assume that interest rates can
take on three possible rates in the next period are
called trinomial models.
o More complex models exist that assume that more than
three possible rates in the next period can be realized.
❖ Interest-Rate Lattice
o Returning to the binomial interest-rate tree in Exhibit 17-7 (as
was seen in Overhead 17-28), each node (bold blue circle: )
represents a time period that is equal to one year from the
node to its left.
o Each node is labeled with an N, representing node, and a
subscript that indicates the path that one-year forward rates
took to get to that node.
o H represents the higher of the two forward rates and L the
lower of the two forward rates from the preceding year.
o For example, node NHH means that to get to that node the
following path for one-year rates occurred:
• The one-year rate realized is the higher of the two rates in
the first year and then the higher of the
one-year rates in the second year.
❖ Interest-Rate Lattice
o Exhibit 17-7 (as was seen in Overhead 17-28) shows the
notation for the binomial interest-rate tree in the third year.
o We can simplify the notation by letting rt be the lower
one-year forward rate t years from now because all the
other forward rates t years from now depend on that rate.
o Exhibit 17-8 (see Overhead 17-31) shows the interest-rate
tree using this simplified notation.
o Before we go on to show how to use this binomial interest-
rate tree to value bonds, we first need to focus on
i. what the volatility parameter ( ) in the expression e2
represents
ii. how to find the value of the bond at each node
Bond’s Value in
Higher-Rate State
One Year Forward
Cash Flow in
VH + C
Higher-Rate State
One-Year Rate at
V
Node Where Bond’s
r*
Value Is Sought
Cash Flow in
VL + C
Lower-Rate State
Bond’s Value in
Lower-Rate State
One Year Forward
Duration
Interpretation: Generic description of the sensitivity of a bond’s price
(as a percent of initial price) to a parallel shift in the yield curve
● The traditional yield spread approach fails to take three factors into
account: (1) the term structure of interest rates, (2) the options
embedded in the bond, and (3) the expected volatility of interest
rates. The static spread measures the spread over the Treasury
spot rate curve assuming that interest rates will not change in the
future.
● The potential investor in a callable bond must be compensated for
the risk that the issuer will call the bond prior to the stated
maturity date. The two risks faced by a potential investor are
reinvestment risk and truncated price appreciation when yields
decline (i.e., negative convexity).
● The traditional methodology for valuing bonds with embedded
options relies on the yield to worst. The limitations of yield
numbers are now well recognized. Moreover, the traditional
methodology does not consider how future interest-rate volatility
will affect the value of the embedded option.