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Lecture Note 05 - Bonds With Other Features
Lecture Note 05 - Bonds With Other Features
Outline
Callable bond
What is a callable bond? Why callable bond?
Pros and cons of calling a bond
Valuing a callable bond
Callable Bondholders
The presence of a call option results in two
disadvantages to the bondholder.
Disadvantage 1: Callable bonds expose
bondholders to reinvestment risk:
Investors are exposed to additional reinvestment
risk due to the call option.
Issuers will call the bonds when the price of the
bond is higher than the strike price, which
happens when the interest rate is low enough.
Bondholders are forced to reinvest the proceeds
received in redemption at a lower interest rate.
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Refunding benefit
= ($3/0.07) ($100 1.25%)
= $42.86 $1.25 = $41.61
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Callable
bond can be considered as having two
components: a non-callable bond and a call
option.
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Calculation
If the bond is not called in year 2, the price of the
bond then is
At node NHH, $105.25/1.067573 = $98.5881
At node NHL, $105.25/1.055324 = $99.7324
At node NLL, $105.25/1.045296 = $100.6892
At node NLL, the bond will be called since the
bond price is higher than the strike price $100.
There are $5.25 coupon payment at the end of
year 2.
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Calculation (contd)
the bond is not called in year 1, the price of the
If
bond then is
At node NH,
At node NL,
Calculation (contd)
At node N, now, the bond price is
The price of the callable bond is $101.4307.
For the non-callable bond, the price of the
bond at node NL is
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Calculation (contd)
The
price of the non-callable bond at node N,
now, is
Therefore, the value of the option embedded in
the callable bond is
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Option-Adjusted Spread
Option-adjusted spread (OAS)
OAS is the spread such that the market price of a
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The
conversion value of a convertible bond is
the value of the bond if it is converted
immediately
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The
market conversion price is the price that
an investor effectively pays for the common stock
if the convertible bond is purchased and then
converted into the common stock
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Investment Characteristics
The investment characteristics of a convertible
bond depend on the stock price
If the stock price is low the straight value is
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The
downside risk of convertible bond is often
estimated by comparing the market price of the
bond with the straight value since the price of
the bond cannot fall below its straight value
The downside risk is measured as a percentage
of the straight value
The higher the premium over straight value, all
other factors constant, the less attractive the
convertible bond.
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Takeover Risk
Corporate takeovers represent another risk to
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5.54%
6.00%
5.44%
6.18%
1.5
3.00
2.72
103.09
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Valuation of Floater
Consider
a $100 par of a floater with coupon rate
set to equal the six-month rate and maturing at
time T. What is the price of the floater on the
coupon date before the maturity date, that is,
time T 0.5?
What
is the price of the floater two coupon dates
before the maturity date, that is, time T 1?
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Fixed/Floater/Inverse Floaters
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Fixed/Floater/Inverse Floaters
FIXED RATE BOND
The fixed rate bond can be split into a floater and an inverse
floater unevenly. 50/50 is the most popular split.
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Fixed/Floater/Inverse Floaters
The sum of the face value of the floater and
inverse floater must equal the face value of the
fixed-rate bond.
The sum of the interest paid on the floater and
inverse floater must always equal the interest
paid on the fixed-rate bond.
Therefor a maximum/minimum interest rate
5.54%
6.00%
5.44%
6.18%
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What
is the cash flows to the floater and the
inverse floater?
What is the coupon rate for the inverse floater?
Answer: for the first period, the coupon rate on
the floater is 5.54%. The coupon payment is
The coupon payment from the fixed rate bond is
Therefore, the coupon payment on the inverse
floater is .
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(contd)
The coupon rate on the inverse floater is
thus
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