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Debt Exam 2: Ch. 18 Analysis of Bonds w/ Embedded Options
Terms in this set (15)
what are 2 drawbacks of traditional approach to valuation of bonds with embedded options?
Traditional analysis for non-Treasury bond involves calculating the difference between the yield to maturity (or yield to call) of the bond and the yield to maturity of a comparable-maturity Treasury, BUT
1. yield for all bonds (treasury v. those with options) fails to take in term structure of IR
2. in terms of putable/callable bonds, expected IR volatility may alter CF
static spread (zero volatility spread)
-measure of spread that investor realizes over entire treasury spot rate curve if bond held to maturity
-calculated as spread that will make PV of CF from corporate bond (when discounted at treasury spot rate + spread) equal to corporate bond's price
why is investor of callable bond exposed to reinvestment risk?
if issuer calls bond when interest rates are lower (price below its market value), investor's proceeds will be reinvested at a lower rate
Typically as rates decrease, you will see bond prices increase, but this is not the case for callable bonds. This phenomenon is called price compression and is an integral aspect of how callable bonds behave.
-bond will be redeemed at call price
price appreciation > price depreciation
for a large change in yield
-as IR fall below a certain level, curve turns inward
price appreciation < price depreciation
for a large change in yield of a given number of basis points
-bond can still trade above call price if its highly likely to be called
positive/negative convexity and coupon rates
higher volatility means lower coupon rate
enters into 2 separate transactions:
1. owner buys noncallable bond from issuer
2. owner sells issuer call option at option price (pmt. lowers value of callable bond)
-investors will be willing to pay higher price than call price to purchase bond
the value of a putable bond is greater than or equal to the value of a nonputable/noncallable/option-free bond?
if interest rate are expected to be volatile, call options will be highly valued
If an on-the-run issue for an issuer is evaluated properly using a binomial model, how would the theoretical value compare to the actual market price?
For an on-the-run issue that is option-free the theoretical value is identical to the bond value found when we discount at either the zero-coupon rates or the one-year forwards. Since the binomial model uses forward rates, it would be consistent with the actual market price given by the standard valuation model for an option-free bond. For example, the model uses two forward rates (a higher and lower rate each step in generating the binomial interest rate tree) that will be consistent with the volatility assumption, the process that is assumed to generate the forward rates, and the observed market value of the bond.
option-adjusted spread (OAS)
used to reconcile value with market price
"option-adjusted" because CF of security whose value we seek are adjusted to reflect embedded options
spread over spot rate curve/benchmark used in valuation or interest-rate tree
the higher the interest rate volatility, the lower the OAS (and vice versa)
binomial interest-rate tree
using treasury spot rates:
-OAS reflects richness/cheapness of security + a credit spread
using issuer's spot curve:
-credit risk already incorporated in analysis
-OAS reflects richness or cheapness
Why is modified duration an inappropriate measure for a high-coupon callable bond?
modified duration measures the sensitivity of a bond's price to interest-rate changes, assuming consistent CF. however, CFs of bonds with embedded options change with interest rates.
instead, use effective duration or option-adjusted duration formula.
bond's price in response to CF changing with IR due to embedded option.
why would the replacement of 10-year Treasuries with high-coupon callable bonds reduce the portfolio's duration?
The higher a callable bond's coupon rate is compared to the market's prevailing yield, the more likely it is to be called and, therefore, the lower the bond's effective duration.
In contrast, a bond with a coupon rate lower than the prevailing market yield is not likely to be called and will thus have an effective duration similar to a noncallable bond. In turn, the greater duration of the bond, the greater its percentage price volatility.
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