Bond Trading 1999 - Bonds with Embedded Options

Bond Trading 1999 - Bonds with Embedded Options - 1 Bonds...

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Unformatted text preview: 1 Bonds with Embedded Options Jonathan Kinlay Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 2 Bonds with Embedded Options Callable & Putable Bonds Yield sensitivity Price compression Option-adjusted convexity & duration Yield to call & yield to worst Yield spread Static spread Option adjusted spread Monte-Carlo techniques Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 3 Callable Bonds Many bonds have embedded option features Callable bonds, putable bonds, etc Callable bonds Give issuer right to redeem the issue call price (par) Call risk As yields fall likelihood increases that issuer will call Investor faces reinvestment risk Compensated by higher potential yield Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 4 Callable Bonds Traditional Analysis Yield to call Calculate yield of bond assuming its expected cash flows are coupon payments to the first call date plus call price Yield to worst Calculate yield to call for all call dates and pick the lowest Assumptions Reinvestment Issue will be called on call date Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 5 Price Yield y* Noncallable Callable Price compression Price-Yield Relationship for Callable Bonds Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 6 Features of Callable Bonds Price compression Limited price appreciate as yields decline Negative convexity As yields fall: Duration increases (as for non-callable) Then duration decreases Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 7 Components of a Callable Bond Callable Bond = Straight Bond - Call Option Higher yield due to call option premium received As yields decline,value of call option increases, hence price compression Pricing of callable bonds Price straight (i.e. non-callable) bond Price call option Interest rate option model Price CB = Price NCB- Price CO Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 8 Option Adjusted Yield Implied Price of Non-Callable Bond: Price NCB = Price CB + Price CO Given option price and market price of callable, we can calculate implied price of NCB Option-Adjusted Yield YTM of implied non-callable bond Rich-Cheap Analysis of Callable Bonds Calculate option-adjusted yield Compare to zero coupon spot yield curve Rich: OAY is low; Cheap: OAY is high Copyright 1999-2006 Investment Analytics Bonds with Embedded Options Slide: 9 Option-Adjusted Yield Example Callable bond...
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Bond Trading 1999 - Bonds with Embedded Options - 1 Bonds...

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