Bonds with embedded

options

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Callable Bonds Drake

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A problem with traditional pricing is that it

ignores options imbedded in the bond such
as a call option.
The call feature increases reinvestment rate
risk since the bond will be called if rates are
low, especially if lower than the coupon rate.
As the yield decreases the price increase
lessens because there is a higher probability
of the bond being called (price compression)
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Valuing a Callable Bond Drake

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You can think of a callable bond as

having two components: A noncallable
bond and a call option. The price of the
callable bond would then be equal to
the noncallable bond price minus the
call option price.
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Valuation Model Review Drake

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Remember from before that the

appropriate rate to use is not a single
rate, but the zero spot rate or the
forward rates (example on next slide)
The value of the callable bond will be
tied directly to the volatility of interest
rates. To price the bond we will use a
binomial tree model.
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5.25% coupon bond, 3 years

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to maturity, yearly Drake University

payments
Assume you have the following observed
yield curve, spot rates, and forward rates.
Maturity YTM Market Value Spot Rate Forward
Rate
1 yr 3.5% 100 3.5% 3.5%
2 yr 4.0% 100 4.01% 4.5225%
3 yr 4.5% 100 4.531% 5.5792%
5.25 5.25 105.25
2
3
102.075
(1.035) (1.0401) (1.04531)
5.25 5.25 105.25
102.075
(1.035) (1.035)(1.04523) (1.035)(1.04523)(1.055792)
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Binomial Tree Model Drake

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We are going to represent the two possible paths

of interest rates in a tree structure.
Let each time be denoted as a decision Node N
with a subscript denoting whether it represent
the higher or lower interest rate environment.
The current level of interest rates is r*, it may
increase to state H or decrease to state L If the
level of interest rates increases to H the bond will
have a value of VH in the next period. Likewise if
rates decrease to L the value will be V L
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Binomial Tree Model Drake

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VH
NH

V

r*
N

VL
NL
Time 0 Time 1
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Value at Time 0 Drake

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The value of the bond at time 0 can be

calculated assuming that there is an equal
chance of obtaining either state.
The expected value at time 0 is then equal to
the PV of total amount you would receive in
each state multiplied by the probability of the
state (in this case 1/2)
The total amount you would receive is the value
or the bond plus any other cash flows received
(For example the coupon payment)
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Binomial Tree Model Drake

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VH

NHCH

V0

r* N
VL
1 VH C H VL CL
V0 NL CL
2 1 r * 1 r *
Time 0 Time 1
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Simple Example Drake

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Assume that the current level of interest

rates is 3.5% as in our previous
example.
If the higher interest rate price is $98
with a coupon of $5 and the lower
interest rate price is $102 with the same
$5 of 98 5 the
1 coupon 5 at time 0 would
value
102
be 101.449
2 1.035 1.035
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Binomial Tree Model

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continued Drake University

Starting today we want to think about the

future path of interest rates.
Start with the time 0 (today) and think
about the future path of interest rates. We
will assume that over the next year there
are two possible outcomes for the one year
rate at time 1.
Let the lower rate be r1L and the higher
rate be r1H
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Binomial Tree Method

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continued Drake University

Assuming the lower rate in the next period the

higher rate can be found from the equation.
r1H=e2r1L
where: e = natural logarithm 2.71828
(x = lny y=ex)

For example let r1L=4.5% and =10%

then r1H = .045e2(.10)=.054963
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Binomial Tree Model Drake

Drake University

VH
CH
NH r1H=.05496

V0

r* N
VL
CL
NL
r1L=.045

Time 0 Time 1
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Extending the model Drake

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It is easy to extend the model to add a

second year.
From each of the decision nodes NH and
NL you can just repeat the same tree.
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Binomial Tree Model Drake

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VHH
CHH
VH NHH r2HH
CH
VHL
NH r1H=.0549
V0
N 6 CHL
r=.035 VL NHL r
2HL

NL CL
r1L=.045 VLL
CLL
NLL r
2LL
Time 0 Time 1 Time
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The Two Year Bond Drake

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Using the observed yield curve from

before, the two year bond would have a
4% coupon rate implying $4 coupon
payments each year.
At maturity the bond will have a value of
$100
Substitute the value in for V HH, VHL,and VLL.
Let the coupon be $4 in each period.
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Binomial Tree Model Drake

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VHH = 100
CHH = 4
VH NHH r2HH
CH = 4
VHL = 100
NH r1H=.0549
V0
N 6 CHL = 4
r=.035 VL NHL r
2HL

NL CL = 4
r1L=.045 VLL= 100
CLL= 4
NLL r
2LL
Time 0 Time 1 Time
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Finding VH and VL Drake

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The values of the bond can be found at

time 1 by applying the earlier formula
1 VH C H VL CL
V0
2 1 r * 1 r *

1 VHH CHH VHL C HL 1 100 4 100 4

VH 98.582
2 1 r1H 1 r1H 2 1.05496 1.05496

1 VLL CLL VHL C HL 1 100 4 100 4

VL 99.522
2 1 r1L 1 r1L 2 1.045 1.045
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Binomial Tree Model Drake

Drake University

VHH = 100
CHH = 4
VH=98.85 NHH r2HH
2

CH = 4 VHL = 100
NH
V0 r1H=.0549
N CHL = 4
r=.035 6VL=99.522 NHL r
2HL

NL CL = 4
r1L=.045 VLL= 100
CLL= 4
NLL r
2LL
Time 0 Time 1 Time
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Iterative Procedure Drake

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We assumed an interest rate of 4.5% for r 1L this is

the correct rate IF V0 can be found given the
current values it the tree and V0 is equal to the
market price of 100
1 VH C H VL C L 1 98.582 4 99.522 4
V0 99.567
2 1 r * 1 r * 2 1.035 1.035
Since the price from the tree is too low, the rate
r1L must be lower to increase the price. Try a new
price and repeat until the correct price 4.074% is
found
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Iterative procedure Drake

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Given the rate of 4.074 the expected

value of the two possible changes in
interest rates is equal to the current
value, in other words it is fairly
priced.
The change in rates requires finding
new values for r1H and for VH and VL
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Binomial Tree Model Drake

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VHH = 100
CHH = 4
VH=99.07 NHH r2HH
1

CH = 4 VHL = 100
NH
V0 r1H=.0497
N CHL = 4
r=.035 6VL=99.929 NHL r
2HL

NL CL = 4
r1L=.0407 VLL= 100
4 CLL= 4
NLL r
2LL
Time 0 Time 1 Time
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Interpretations Drake
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r1H and r1Lare a set of forward rates from

time 1 to time 2 or 1f1 as it was
previously called.
Notice that since the change in rates
makes a difference in the value of the
bond, for each forward rate we will have
a different value of the bond.
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The next step, time 3 Drake

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The model could be extended again to

include the next year. The YTM for the three
year treasury was 4.5% so the coupons at
every time period become 4.50.
The goal is to find a value for r2LL that will
allow us to move from right to left through
the tree to produce a value of 100 again at V 0
r2HL=r2LLe2 as before and r2HH=r2HLe2r2LLe4
the correct rate is then
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Binomial Tree Model Drake

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VHH =
97.886
VH NHH CHH = 4.50
=98.074 r2HH=.0675

CH = 4.50 VHL =
7
NH
V0
N r1H=.0497 99.022
r=.035 6VL=99.926 NHL CHL = 4.50

NL CL = 4.50 r2HL
r1L=.0407 V LL= 100
=.05532
4 CLL= 4.50
NLL r =.0453
2LL
Time 0 Time 1 Time
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Valuing an Option Free Bond Drake

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The rates in the binomial tree now

represent the correct rates for the on the
run treasury yield curve that we started
with. It is now possible to use it to value
the three year 5.25% coupon bond.
Starting with year three the values V HH,
VHL, and VLL can be found then we can
work right to left through the tree
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Binomial Tree Model Drake

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VHH =
98.588
VH NHH CHH = 5.25
=99.461 r2HH=.0675

CH = 5.25 VHL =
7
NH
V0
N r1H=.0497 99.732
r=.035 6VL=101.33 NHL CHL = 5.25

NL 3 r2HL
CL = 5.25 V LL=
=.05532
r1L=.0407 100.689
4 NLL CLL= 5.25
Time 0 Time 1 r2LLTime
=.0453
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Value of the bond Drake

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1 VH C H VL C L
V0
2 1 r * 1 r *
1 99.461 5.25 101.333 5.25
102.075
2 1.035 1.035

The same value as we calculated before!!!

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Valuing a Call Option Drake

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Assume that the the bond can be called at

the end of the first year or later for a call
price of $100.

If the value at a node is greater than $100

then the bond will be called (the yield is less
than the coupon) and the firm can refinance
at a lower rate. Starting on the right, if the
value exceeds 100 it needs to be replaced,
then the tree is worked right to left again.
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Binomial Tree Model Drake

Drake University

VHH =
98.588
VH NHH CHH = 5.25
=99.461 r2HH=.06757

CH = 5.25 VHL =
NH
V0
N r1H=.0497 99.732
r=.035 6VL=101.00 NHL CHL = 5.25
r2HL
NL 1 VLL=
VL=100 =.05532
100.689
CL = 5.25 V =100
LL
NLL
r1L=.0407 CLL= 5.25
Time 0 Time 1
4 Time
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Value of callable bond Drake

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1 VH C H VL C L
V0
2 1 r * 1 r *
1 99.461 5.25 100 5.25
101.4302
2 1.035 1.035

The value has decreased because of the

call option
The value of the call option is then
102.075-101.4302=0.6448
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Put option Drake

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The same model could be used to value a

put option.
Now, you look at increases in rates that
lower the price.
If the value of the bond at the node is less
than the puttable value then the option
would be exercised and the value of the
bond becomes the put value.
Assume that our bond has a put option after
year one with the puttable value being $100
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Binomial Tree Model (Put) Drake

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VHH =
98.588

VH VHH=100
NHH
=100.261 CHH = 5.25

CH = 5.25 rV2HH =
HL =.06757
NH
V0
N r1H=.04976 99.732
r=.035 VL=101.46 NHL VHL=100
CHL = 5.25
NL 1
CL = 5.25 rV2HL
LL=

r1L=.0407 =.05532
100.689
4 NLL C = 5.25
LL
Time 0 Time 1
r Time
=.0453
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Value of puttable bond Drake

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1 VH C H VL C L
V0
2 1 r * 1 r *
1 100.261 5.25 101.461 5.25
102.523
2 1.035 1.035

The value has increased because of the put

option.
The value of the put option is
102.075 102.523= -0.448
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Modeling Risk Drake

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Modeling risk is the risk that the valuation

model has produced an incorrect result
due to assumptions used in the model.

Higher volatility lowers the value of the

call option (raises value of put)
Lower volatility raises the value of the a
call option (lower the value of a put)
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Option Adjusted Spread Drake

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The constant spread that when added to

all the forward rates in the binomial tree
will make the theoretical value equal to
the market price.
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OAS Intuition Drake

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Converts the difference between the

valuation and the market price into a
spread measure.

The key is the inputs in the model

If the tree uses the treasury spot curve, the
OAS represents the richness or cheapness of
the security plus a credit spread
If the tree uses issuers spot rate curve,
then the credit risk is already incorporated.
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OAS and total yield spreads Drake

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The OAS is attempting to separate the

amount of the nominal spread that is the
result of option risk. Therefore it reports a
spread that is adjusted for the option.
Example: Assume you have calculated the
OAS of a BBB callable corporate bond
compared to non callable treasuries to be
120 Bp. would imply that the BBB pays 120
Bp more because of the liquidity and credit
risk etc. the spread has removed the portion
of the spread attributable to the option.
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OAS and benchmarks Drake

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In the previous example the OAS was a

representation of credit and liquidity risks. If
instead of using the on the run treasury as a
benchmark we used the on the run issues
for the same issuer (the issuer of the BBB).
Then credit risk is also not part of the
spread, only liquidity and other factors.
OAS is the spread after adjusting for options,
what it actually represents however
depends upon the benchmark being used
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OAS in our example Drake

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Assume that the 5.25% callable three year

coupon bond is currently selling for $101.17
Previously we found the price to be
$101.4302
The OAS would be the additional yield
added to the binomial interest rate tree at
every yield that produced a value for the
bond of $101.17, in this case the OAS is 45
Bp
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Binomial Tree Model Drake

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VHH =
102.6309
VHH = 100
VH NHH
CHH = 5.25
=99.833
r2HH=.07208
V
CH = 5.25 HL = 103.817
NH VHL = 100
V0 r1H=.00542
N
CHL = 5.25
r=.035 6L=100.69
V NHL
r2HL =.0598
NL 46 VLL=
VL=100 104.809
CL = 5.25 V =100
LL
NLL
r1L=.04524 CLL= 5.25
Time 0 Time 1 Time
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Value of callable bond (with
Drake
OAS) Drake University

1 VH C H VL C L
V0
2 1 r * 1 r *
1 99.83306 5.25 100 5.25
101.1703
2 1.035 1.035
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Funding Cost as a
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Benchmark Drake University

Often the on the run issues of the LIBOR is used

as the benchmark.
LIBOR is used as a benchmark borrowing rate
that the institution pays to obtain funds. It can
then compare its cost of funding to LIBOR by
looking at the spread above LIBOR it pays to
obtain funds.
As long as the assets spread relative to LIBOR is
greater than the spread the institution must
pay to obtain funding, it is covering the funding
cost.
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Effective Duration and

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Convexity Drake University

Effective Duration (option adjusted

duration) allows a yield change to
change the expected future cash flows.
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Quick approximation of
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duration and convexity Drake University

P- = the price if yield is decreased by x Bp

P+ = the price if yield is increased by x Bp
P0 = the initial price y=change in rate (x
Bp in P- P dec
form) duration
2(P0 )(y)

P P 2( P0 )
convexity
(P0 )(y)2
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Calculating P+ and P- Drake

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1) Calculate the OAS

2) Shift the on the run yield curve by a
small basis points
3) Construct a binomial interest rate tree
based on the new yield curve
4) To each of the short rates add the OAS
to adjust the tree
5) Use the adjusted tree to determine the
value of P.
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Valuing a Step Up Callable

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Note Drake University

The Binomial model can be expanded to

cover other types of options.
One possibility is a note whose coupon rte
changes over the life of the note. In this case
the coupon rate may increase in the future.
Initially, the procedure is the same as before.
After developing the interest rate tree, the
bond is valued using the coupon rates that
correspond to what the bond will pay.
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Valuing a Floating Rate Note Drake

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On a floating rate bond the payment at the end

of the year is determined by the rate at the
beginning of the year.
Therefore the coupon payment for each node will
be based off of the interest rate for that node
(the rate at the beginning of the period
determines the coupon at the end of the period).
The valuation therefore uses the coupon for that
node as the payment at the next point in time.
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A Capped Floater Drake

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If the floating rate bond has a cap, then

whenever the coupon is above the cap
the value of the coupon will be based off
of the cap.
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Analysis of Convertible
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Bonds Drake University

A convertible bond can allows the holder to

convert the bond into a predetermined
number of shares of common stock of the
issuer.
It may also be callable and puttable.
Exchangeable securities allow conversion to
the stock of another firm.
The conversion privilege may extend over
the entire life of the of the issue or a portion
of the issue
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Conversion Ratio Drake

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The conversion ratio is the number of shares the

holder will receive if the conversion option is
exercised.
Assume that the conversion ratio is 25, this would
imply that you would receive 25 shares for each
$1,000 of par value.
The conversion price is the price per share implied by
the conversion ratio. In the example above this
would be $1000/25 = $40
If not issued at par, the conversion price is found by
dividing the issue price per 1000 by the conversion
ratio.
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Other embedded options Drake

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Often the convertible is also callable,

usually with a non callable period at the
beginning of the period of the issue
The issue may also be puttable. Hard
Put the issuer must redeem with cash
Soft Put the issuer may use common
stock, cash, or subordinated notes, or a
combination of the three
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Minimum Value Drake

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The conversion (or parity) value is the value

of the security if it is converted immediately.
The minimum value is then the greater of 1)
the conversion price and 2) its value as a
security without the conversion option (also
called the straight value or investment value).
If the security does not sell a the greater of
the two, then there are arbitrage possibilities.
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Market Conversion Price Drake

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If the convertible bond is bought then

converted immediately into stock, the
buyer is effectively paying a share
price based on the value of the
security.
The market conversion
marketprice
price ofis
market
convertible security
conversion
conversion ratio
price
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Market Conversion Price Drake

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If the actual market price increases above

the market conversion price the value of
the convertible bond should increase by
the same percentage.
Buying the convertible bond rather than
the underlying stock results in basically
paying a premium for the stock an can be
expressed as a ratio based on the market
price.
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Why pay a premium? Drake

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The investor may be willing to pay the

premium if there is an expectation of
receiving a higher current income from
the coupon payments than from possible
dividends on the stock.
One way to address this is looking at the
amount of time it takes to recover the
premium paid (ignoring the time value of
money)
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Premium Payback Period Drake

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The amount of time to recover the premium

is
market conversion
premuin
premium per share
payback
favorable income
period
differential per share
market conversion price - current market price

copon interest - (conversion ratio x common stock dividend per share)

conversion ratio
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Downside Risk Drake

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It is often assumed that the price of the

convertible security cannot fall below the
straight value, therefore some participants
look at the ratio of the market price to the
straight value as a measure of downside
risk.
However the straight value changes as
interest rates change so this does not truly
provide a good measure of downside risk .
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Up side potential Drake

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The up side depends upon the valuation of

the common stock and the potential for
gain the stock price.
If the straight value is significantly higher
than the value implied by the common
stock price then it is referred to as a fixed
income equivalent or busted convertible.
If the conversion value from the stock price
is higher than the straight value it is a
common stock equivalent.
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Option based value Drake

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We have ignored the true value of the

security
The convertible security value should equal
the straight value plus the value of a call
option of the stock of the firm.
IF the bond has a call feature then the
value becomes: the straight value plus the
value of the cal option on the stock minus
the value of the call option on the bond.