BUS326 Lect 12 Risky Debt Callable Bonds - ANALYSIS OF BONDS WITH EMBEDDED OPTIONS CALLABLE BONDS REFERENCE Fabozzi F.J(2004 Bond Markets Analysis and

BUS326 Lect 12 Risky Debt Callable Bonds - ANALYSIS OF...

This preview shows page 1 - 9 out of 9 pages.

Image of page 1

Subscribe to view the full document.

Image of page 2
Image of page 3

Subscribe to view the full document.

Image of page 4
Image of page 5

Subscribe to view the full document.

Image of page 6
Image of page 7

Subscribe to view the full document.

Image of page 8
Image of page 9

Unformatted text preview: ANALYSIS OF BONDS WITH EMBEDDED OPTIONS - CALLABLE BONDS REFERENCE: Fabozzi, F.J. (2004). Bond Markets, Analysis and Strategies, (5th ed) New Jersey: Prentice-Hall, Chapter 16, pp. 343-373. The notes that follow draw heavily from Fabozzi — Chapter 16. DRAWBACKS OF TRADITIONAL YIELD SPREAD ANALYSIS . Consider two 8.8 % coupon 25—year bonds paying interest semi—annually; _ ' ($) MATURITY (%) Treasury 915 Corporate 87.0798 10.24 The yield spread is difference between 10.24% and 9.15%, that is 1.09% or 109 basis points (BP). However, the traditional yield spread ignores the 0 term structure of interest rates 0 existence of embedded options ... callable/putable bonds STATIC SPREAD: AN ALTERNATIVE TO YIELD SPREAD DEMONSTRATION EXAMPLE: FABOZZI 16-2 Is the static spread for a three-year 9% coupon corporate bond selling at $105.58 given the theoretical Treasury spot rate below, 50, 100, or 200 basis points? SPOT RATE (%) (NOTE RATE QUOTED PA.) 4.0 The static. spread is a measure of the spread an investor would realize over the entire Treasury spot rate curve if the bond is HELD to MATURITY. The difference between the static spread and the traditional yield curve increases with 0 increasing maturity 0 the steeper the yield curve 0 coupon rate 0 amortised (equal) cash flows compared to bullet payments CALLABLE BONDS AND THEIR INVESTMENT CHARACTERISTICS The holder of callable bond has given the issuer the right to call the issue prior to the expiration date. The presence of a call option has the following disadvantages to the bondholder - Since an issuer will call a bond when the yield on the bonds in the market is lower than the issue’s coupon rate - the bondholder will be exposed to reinvestment risk. it The price appreciation potential for a callable bond in a declining interest rate environment is limited - price compression. I PRICE-YIELD RELATIONSHIP EORVA CALLABLE BOND ' Examine Exhibit 16— 4 As will be demonstrated later it is important to note that a bond can trade above its call price even if 1t is likely to be called. COMPONENTS OF A BOND WITH AN EMBEDDED OPTION Callable bond price w noncallable bond price — call option price VALUATION MODEL The following approach Will be employed: - valuation of option-«free bonds; 0 introduction of interest rate volatility; 0 construction the binomial interest-rate tree; 0 application to valuation of an option—free bond; 0 valuation of a callable corporate bond; and o determination of the call option value VALUATION OF OPTION-«FREE BONDS Consider the following-hypothetical yield curve: Yield to Maturity Market Value (YearS) (%) ($) 1 3.50 100 2 4.00 100 3 4.50 100 By assuming annual coupon payments determine the spot rate and one-year forward rate. INTEREST-RATE VOLATILITY Use the notation described in Fabozzi (2004:357—359). It is assumed that the one—year forward rate can evolve based on a random process called a lognormal random walk with a certain probability. Thus __M 20‘ F} ,H "" 7” 1,L e (7 == assumed volatility ofthe one—year forward-"rate r131: = the lower onewyear rate one year from now; 7” 1H E the higher one-year rate one year from now In-the second year there are three possible values forghe one-yearrate, F2,HH ,r2,HL and V2,” . It can be shown that: 40' r2,LLe r2,HH and r2,HL r2,LLe We also will assume that there is an equal chance of either an upward or downward movement in the interest rates. CONSTRUCTING THE BINOMIAL INTEREST— RATE TREE To obtain the bond’s value at a node we determine the present value of the expected cash flows by discounting by the one-year forward rate at the node. Since at the node there is an equal: chance cf higher and lower forward rate being present an average of the present values is computed. " “f APPLICATION TO VALUING AN OPTION—FREE BOND VALUING A CALLABLE CORPORATE BOND DETERNIINING THE CALL OPTION VALUE (OR OPTION COST) Since Callable bond price w noncallable bond price - call option price then it follows Call option price = noncallable bond price - call bond price ...
View Full Document

  • Spring '17
  • callable bond, callable bond price, noncallable bond price, callable corporate bond

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern

Ask Expert Tutors You can ask 0 bonus questions You can ask 0 questions (0 expire soon) You can ask 0 questions (will expire )
Answers in as fast as 15 minutes