11_09_2010 Callable_Debt

11_09_2010 Callable_Debt - FIXED INCOME SECURITIES NOVEMBER...

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1 NAME OF INITIATIVE OR GROUP FIXED INCOME SECURITIES Fall 2010 – FNCE 235/725 Prof. Stephan Dieckmann NOVEMBER 9, 2010 CALLABLE DEBT
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2 Callable Bonds • A callable bond gives the issuer the right to call the bond issue prior to maturity, and repay the bondholder early. The bond contract specifies the dates at which that can happen, as well as the call price. • The holder of a callable bond can think of her position as equivalent to holding a portfolio of two separate securities. This portfolio contains (1) a non-callable bond with the same coupons and maturity as the callable bond and (2) a short position in a call option on this same non-callable bond. That is, a synthetic alternative to holding a callable bond involves owning a non- callable bond and writing a call option on this same bond. What are they?
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3 Callable Bonds Why does Freddie Mac issue callable bonds? A large portion of Freddie Mac’s assets are subject to prepayment risk . When mortgage interest rates fall borrowers tend to pre-pay their mortgages and refinance their homes with new mortgages. • To mitigate this risk, Freddie Mac can fund its assets with callable debt. While this could also be done in the derivatives market, Freddie Mac appears to prefer issuing callable debt since it does not increase additional credit risk to derivative
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11_09_2010 Callable_Debt - FIXED INCOME SECURITIES NOVEMBER...

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