Bonds With Embedded Options

Global Edition
Chapter 17
Analysis of Bonds
with Embedded
Options
Learning Objectives
After reading this chapter, you will understand

 the drawbacks of the traditional yield spread analysis
 what static spread is and under what conditions it would differ
from the traditional yield spread
 the disadvantages of a callable bond from the investor’s
perspective
 the yield to worst and the pitfalls of the traditional approach to
valuing callable bonds
 the price–yield relationship for a callable bond
 negative convexity and when a callable bond may exhibit it
 how the value of a bond with an embedded option can be
decomposed
 the lattice method and how it is used to value a bond with
an embedded option
© 2013 Pearson Education

Learning Objectives (continued)
After reading this chapter, you will understand

 how a binomial interest-rate tree is constructed to be
consistent with the prices for the on-the-run issues of an
issuer and a given volatility assumption
 what an option-adjusted spread is and how it is calculated
using the binomial method
 the limitations of using modified duration and standard
convexity as a measure of the price sensitivity of a bond with
an embedded option
 the difference between effective duration and modified
duration
 how effective duration and effective convexity are calculated
using the binomial method

Drawbacks of Traditional Yield
Spread Analysis
Traditional analysis of the yield premium for a non-Treasury bond
involves calculating the difference between the yield to maturity
(or yield to call) of the bond in question and the yield to maturity
of a comparable-maturity Treasury. The latter is obtained from the
Treasury yield curve. For example, consider two 8.8% coupon
25-year bonds:
Issue Price Yield to Maturity (%)

Treasury $96.6133 9.15
Corporate 87.0798 10.24
The yield spread for these two bonds as traditionally computed is 109
basis points (10.24% minus 9.15%). The drawbacks of this convention,
however, are (1) the yield for both bonds fails to take into
consideration the term structure of interest rates, and (2) in the case of
callable and/or putable bonds, expected interest rate volatility may
alter the cash flow of a bond.

Static Spread: An Alternative
to Yield Spread
 In traditional yield spread analysis, an investor
compares the yield to maturity of a bond with the yield
to maturity of a similar maturity on-the-run Treasury
security.
 Such a comparison makes little sense, because the
cash flow characteristics of the corporate bond will not
be the same as that of the benchmark Treasury.
 The proper way to compare non-Treasury bonds of the
same maturity but with different coupon rates is to
compare them with a portfolio of Treasury securities
that have the same cash flow.
 The corporate bond’s value is equal to the present
value of all the cash flows.

to Yield Spread (continued)
 The corporate bond’s value, assuming that the cash
flows are riskless, will equal the present value of the
replicating portfolio of Treasury securities.
 In turn, these cash flows are valued at the Treasury spot
rates. Exhibit 17-1 shows how to calculate the price of a
risk-free 8.8% 25-year bond assuming the Treasury spot
rate curve shown in the exhibit. (See truncated version
of Exhibit 17-1 in Overhead 17-7.)
o The price would be $96.6133.
o The corporate bond’s price is $87.0798, less than the
package of zero-coupon Treasury securities, because
investors in fact require a yield premium for the risk
associated with holding a corporate bond rather than
a riskless package of Treasury securities.

Exhibit 17-1 Calculation of Price of a
25-Year 8.8% Coupon Bond Using Treasury
Spot Rates
Treasury
Present
Period Cash Flow Spot
Value
Rate (%)
1 4.4 7.00000 4.2512
2 4.4 7.04999 4.1055
3 4.4 7.09998 3.9628
4 4.4 7.12498 3.8251
5 4.4 7.13998 3.6922
6 4.4 7.16665 3.5622
…. …. …. ….
46 4.4 10.10000 0.4563
47 4.4 10.30000 0.4154
48 4.4 10.50000 0.3774
49 4.4 10.60000 0.3503
50 104.4 10.80000 7.5278
Theoretical price 96.6134

 The static spread, also referred to as the zero-volatility spread,
is a measure of the spread that the investor would realize over
the entire Treasury spot rate curve if the bond is held to
maturity.
 It is not a spread off one point on the Treasury yield curve, as
is the traditional yield spread.
 The static spread is calculated as the spread that will make the
present value of the cash flows from the corporate bond, when
discounted at the Treasury spot rate plus the spread, equal to
the corporate bond’s price.
 A trial-and error procedure is required to determine the static
spread.
o Exhibit 17-2 illustrates the calculation of the static spread
for a 25-year 8.8% coupon corporate bond. (See truncated
version of Exhibit 17-2 in Overhead 17-9.)

Exhibit 17-2 Calculation of the Static Spread
for a 25-Year 8.8% Coupon Corporate Bond
Present Value if Spread Used Is:
Treasury Spot
Period Cash Flow 100 BP 110 BP 120 BP
Rate (%)
1 4.4 7.00000 4.2308 4.2287 4.2267

2 4.4 7.04999 4.0661 4.0622 4.0583
3 4.4 7.09998 3.9059 3.9003 3.8947
4 4.4 7.12498 3.7521 3.7449 3.7377
5 4.4 7.13998 3.6043 3.5957 3.5871
…. …. …. …. …. ….
46 4.4 10.10000 0.3668 0.3588 0.3511
47 4.4 10.30000 0.3323 0.3250 0.3179
48 4.4 10.50000 0.3006 0.2939 0.2873
49 4.4 10.60000 0.2778 0.2714 0.2652
50 104.4 10.80000 5.9416 5.8030 5.6677
Total present value 88.5474 87.8029 87.0796

 Exhibit 17-3 shows the static spread and the traditional yield
spread for bonds with various maturities and prices, assuming the
Treasury spot rates shown in Exhibit 17-1. (See truncated version
of Exhibit 17-3 in Overhead 17-11.)
 Notice that the shorter the maturity of the bond, the less the
static spread will differ from the traditional yield spread.
 The magnitude of the difference between the traditional yield
spread and the static spread also depends on the shape of the
yield curve.
 The steeper the yield curve, the more the difference for a given
coupon and maturity.
 Another reason for the small differences in Exhibit 17-3 is that the
corporate bond makes a bullet payment at maturity.
 The difference between the traditional yield spread and the static
spread will be considerably greater for sinking fund bonds and
mortgage-backed securities in a steep yield curve environment.

Exhibit 17-3 Comparison of Traditional Yield
Spread and Static Spread for Various Bondsa
Spread (basis points)
Yield to
Bond Price Maturity (%) Traditional Static Difference
25-year 8.8% Coupon Bond
Treasury 96.6133 9.15 — — —
A 88.5473 10.06 91 100 9
B 87.8031 10.15 100 110 10
C 87.0798 10.24 109 120 11
…. …. …. …. …. ….
5-year 8.8% Coupon Bond
Treasury 105.9555 7.36 — — —
J 101.7919 8.35 99 100 1
K 101.3867 8.45 109 110 1
L 100.9836 8.55 119 120 1
aAssumes Treasury spot rate curve given in Exhibit 17-1.

Callable Bonds and Their
Investment Characteristics
 The presence of a call option results in two disadvantages to
the bondholder:
i. callable bonds expose bondholders to reinvestment risk
ii. price appreciation potential for a callable bond in a
declining interest-rate environment is limited
o This phenomenon for a callable bond is referred to as
price compression.
 If the investor receives sufficient potential compensation in
the form of a higher potential yield, an investor would be
willing to accept call risk.

(continued)
 Traditional Valuation Methodology for Callable Bonds
o When a bond is callable, the practice has been to calculate
a yield to worst, which is the smallest of the yield to
maturity and the yield to call for all possible call dates.
o The yield to call (like the yield to maturity) assumes that
all cash flows can be reinvested at the computed yield—in
this case the yield to call—until the assumed call date.
o Moreover, the yield to call assumes that
i. the investor will hold the bond to the assumed call date
ii. the issuer will call the bond on that date.
o Often, these underlying assumptions about the yield to call
are unrealistic because they do not take into account how
an investor will reinvest the proceeds if the issue is called.

(continued)
 Price-Yield Relationship for a Callable Bond
o The price–yield relationship for an option-free bond is convex.
o Exhibit 17-4 (see Overhead 17-15) shows the price–yield
relationship for both a noncallable bond and the same bond if it is
callable.
o The convex curve a–a' is the price–yield relationship for the
noncallable (option-free) bond.
o The unusual shaped curve denoted by a–b is the price–yield
relationship for the callable bond.
o The reason for the shape of the price–yield relationship for the
callable bond is as follows.
• When the prevailing market yield for comparable bonds is
higher than the coupon interest, it is unlikely that the issuer
will call the bond.
o If a callable bond is unlikely to be called, it will have the same
convex price–yield relationship as a noncallable bond when yields
are greater than y*.

Exhibit 17-4 Price-Yield Relationship for a
Noncallable and Callable Bond
Price
a’
Noncallable Bond
a’- a
b
Callable
Bond
a-b a
y* Yield

(continued)
o As yields in the market decline, the likelihood that yields
will decline further so that the issuer will benefit from
calling the bond increases.
o The exact yield level at which investors begin to view the
issue likely to be called may not be known, but we do
know that there is some level, say y*.
o At yield levels below y*, the price-yield relationship for the
callable bond departs from the price-yield relationship for
the noncallable bond.
o For a range of yields below y*, there is price compression–
that is, there is limited price appreciation as yields decline.
o The portion of the callable bond price-yield relationship
below y* is said to be negatively convex.

(continued)
o Negative convexity means that the price appreciation
will be less than the price depreciation for a large
change in yield of a given number of basis points.
• For a bond that is option-free and displays positive
convexity, the price appreciation will be greater
than the price depreciation for a large change in
yield.
• The price changes resulting from bonds exhibiting
positive convexity and negative convexity are
shown in Exhibit 17-5 (see Overhead 17-18).
o It is important to understand that a bond can still
trade above its call price even if it is highly likely to be
called.

Exhibit 17-5 Price Volatility Implications of
Positive and Negative Convexity
Absolute Value of Percentage Price Change

Change in Interest Rates Positive Convexity Negative Convexity
-100 basis points X% Less than Y%

+100 basis points Less than X% Y%

Components of a Bond with an
Embedded Option
 To develop a framework for analyzing a bond with an embedded option, it
is necessary to decompose a bond into its component parts.
 A callable bond is a bond in which the bondholder has sold the issuer a call
option that allows the issuer to repurchase the contractual cash flows of the
bond from the time the bond is first callable until the maturity date.
 The owner of a callable bond is entering into two separate transactions:
i. buys a noncallable bond from the issuer for which she pays some price
ii. sells the issuer a call option for which she receives the option price
 A callable bond is equal to the price of the two components parts; that is,
callable bond price = noncallable bond price – call option price
 The call option price is subtracted from the price of the noncallable bond
because when the bondholder sells a call option, she receives the option
price.
 Graphically, this can be seen in Exhibit 17-6 (see Overhead 17-20).
 The difference between the price of the noncallable bond and the callable
bond at any given yield is the price of the embedded call option.

Exhibit 17-6 Decomposition of a Price of a
Callable Bond
Note: At y** yield level: PNCB = noncallable bond price

PCB = callable bond price
Price PNCB - PCB = call option price
a’
PNCB
Noncallable Bond
PCB a’- a
b
Callable
Bond
a-b a
y** y* Yield

Components of a Bond with an
Embedded Option (continued)
 The logic applied to callable bonds can be similarly applied
to putable bonds.
 In the case of a putable bond, the bondholder has the right
to sell the bond to the issuer at a designated price and
time.
 A putable bond can be broken into two separate
transactions.
i. The investor buys a noncallable bond.
ii. The investor buys an option from the issuer that allows
the investor to sell the bond to the issuer.
 The price of a putable bond is then
putable bond price = non-putable bond price
+ put option price

Valuation Model
 The bond valuation process requires that we use the theoretical spot
rate to discount cash flows.
 This is equivalent to discounting at a series of forward rates.
 For an embedded option the valuation process also requires that we
take into consideration how interest-rate volatility affects the value
of a bond through its effects on the embedded options.
 Depending on the structure of the security to be analyzed, three
models can be used to account for the valuation effect of embedded
options.
i. The first model is for a bond that is not a mortgage-backed
security or asset-backed security and which can be exercised at
more than one time over its life.
ii. The second case is a bond with an embedded option where the
option can be exercised only once.
iii. The third model is for a mortgage-backed security or certain
types of asset-backed securities.

Valuation Model (continued)
 Valuation of Option-Free Bonds
o The price of an option-free bond is the present value of the cash flows
discounted at the spot rates. To illustrate this, we can use the following
hypothetical yield curve:
Maturity Y i e ld t o Market
Years M a t u r i t y (%) Value
1 3.50 100
2 4.00 100
3 4.50 100
o We can simplify the illustration by assuming annual-pay bonds. Using

the bootstrapping methodology, the spot rates and the one-year
forward rates can be obtained.
Spot O ne – Y e a r
Years R a t e (%) F or w a r d R a t e
1 3.500 3.500
2 4.010 4.523
3 4.541 5.580

 Valuation of Option-Free Bonds

o EXAMPLE. Consider an option-free bond with three years
remaining to maturity and a coupon rate of 5.25%.
o The price of this bond can be calculated in one of two ways,
both producing the same result.
i. The coupon payments can be discounted at the zero-coupon
rates:
$5.25 $5.25 $100  $5.25
   $102.075
1.035 1.0401 2 3
1.04541
ii. The second way is to discount by the one-year forward rates:
$5.25 $5.25 $100 + $5.25

   $102.075
1.035 1.035 1.04523 1.035 1.04523 1.05580

 Introducing Interest-Rate Volatility

o When we allow for embedded options, consideration
must be given to interest-rate volatility.
o This can be done by introducing an interest-rate tree,
also referred to as an interest-rate lattice.
o This tree is nothing more than a graphical depiction
of the one-period forward rates over time based on
some assumed interest-rate model and interest-rate
volatility.

 Interest-Rate Model
o As explained in the previous chapter, an interest-rate model is
a probabilistic description of how interest rates can change
over the life of a financial instrument being evaluated.
o An interest-rate model does this by making an assumption
about the relationship between the level of short-term interest
rates and interest-rate volatility (e.g., standard deviation of
interest rates).
o The interest-rate models commonly used are arbitrage-free
models based on how short-term interest rates can evolve
(i.e., change) over time.
o The interest-rate models based solely on movements in the
short-term interest rate are referred to as one-factor models.
o More complex models would consider how more than one
interest rate changes over time.

 Interest-Rate Lattice
o Exhibit 17-7 (see Overhead 17-28) shows an example
of the most basic type of interest-rate lattice or tree, a
binomial interest-rate tree. The corresponding model is
referred to as the binomial model.
o In this model, it is assumed that interest rates can
realize one of two possible rates in the next period. In
the valuation model we present in this chapter, we will
use the binomial model.
o Valuation models that assume that interest rates can
take on three possible rates in the next period are
called trinomial models.
o More complex models exist that assume that more than
three possible rates in the next period can be realized.

Exhibit 17-7 Three-Year Binomial
Interest-Rate Tree
r3HHH
NHHH
r2HH
NHH
r1H
r3HHL
NH
NHHL
r0
r2HL
N
NHL
r1L r3HLL
NL NHLL
r2LL
NLL
r3LLL
NLLL
Today 1 Year 2 Years 3 Years

o Returning to the binomial interest-rate tree in Exhibit 17-7 (as
was seen in Overhead 17-28), each node (bold blue circle: )
represents a time period that is equal to one year from the
node to its left.
o Each node is labeled with an N, representing node, and a
subscript that indicates the path that one-year forward rates
took to get to that node.
o H represents the higher of the two forward rates and L the
lower of the two forward rates from the preceding year.
o For example, node NHH means that to get to that node the
following path for one-year rates occurred:
• The one-year rate realized is the higher of the two rates in
the first year and then the higher of the
one-year rates in the second year.

o Exhibit 17-7 (as was seen in Overhead 17-28) shows the
notation for the binomial interest-rate tree in the third year.
o We can simplify the notation by letting rt be the lower
one-year forward rate t years from now because all the
other forward rates t years from now depend on that rate.
o Exhibit 17-8 (see Overhead 17-31) shows the interest-rate
tree using this simplified notation.
o Before we go on to show how to use this binomial interest-
rate tree to value bonds, we first need to focus on
i. what the volatility parameter ( ) in the expression e2
represents
ii. how to find the value of the bond at each node

Exhibit 17-8 Three-Year Binomial
Interest Rate Tree with One-Year r3e6
Forward Rates NHH
4 r2e
NHH
r1e2 r3e4
NH NHH
r0 r2e2
N NHL
r1
NL r3e2
NHLL
r2
NLL
r3
NLLL
Today 1 Year 2 Years 3 Years

Lower 1-yr forward rate r1 r2 r3
 Volatility and the Standard Deviation

o In the binomial model, it can be shown that the standard
deviation of the one-year forward rate is equal to r0.
o The standard deviation is a statistical measure of
volatility.
o For now it is important to see that the process that we
assumed generates the binomial interest-rate tree (or
equivalently, the forward rates) implies that volatility is
measured relative to the current level of rates.
• EXAMPLE. If  is 10% and the one-year rate (r0) is 4%,
what is the standard deviation of the one-year forward
rate ? What is if r0 = 12%?
r0 = 4% × 10% = 0.4% or 40 basis points
r0 = 12% × 10% = 1.2% or 120 basis points

 Determining the Value at a Node

o In the binomial model, we find the value of the bond at a
node is as illustrated in Exhibit 17-9 (see Overhead 17-34).
o Calculate the bond’s value at the two nodes to the right of
the node where we want to obtain the bond’s value.
o The cash flow at a node will be either
i. the bond’s value if the short rate is the higher rate plus
the coupon payment
ii. the bond’s value if the short rate is the lower rate plus
the coupon payment.
• the value is the present value of the expected cash flows
o To get the bond’s value at a node we follow the fundamental
process for valuation:
• the appropriate discount rate to use is the one-year
forward rate at the node.

Exhibit 17-9 Calculating a Value at a Node
Bond’s Value in
Higher-Rate State
One Year Forward
Cash Flow in
VH + C
Higher-Rate State
One-Year Rate at
V
Node Where Bond’s
r*
Value Is Sought
Cash Flow in
VL + C
Lower-Rate State
Bond’s Value in
Lower-Rate State
One Year Forward

 Constructing the Binomial Interest-Rate Tree

o To construct the binomial interest-rate tree, we use current on-
the-run yields and assume a volatility, σ.
o The root rate for the tree, r0, is simply the current one-year
rate.
o In the first year there are two possible one-year rates, the
higher rate and the lower rate.
o What we want to find is the two forward rates 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.
o There is no simple formula for this. It must be found by an
iterative process (i.e., trial and error).
o The steps are described in Overheads 17-36, 17-37, and
17-38 and illustrated in Exhibits 17-10 and 17-11
(see Overheads 17-39 and 17-40).


→ Step 1: Select a value for r1. Recall that r1 is the lower one-year forward rate
one year from now. In this first trial we arbitrarily selected a value of 4.5%
for r1.
→ Step 2: Determine the corresponding value for the higher one-year forward
rate. This rate is related to the lower one-year forward rate as follows: r1(e2).
This value is reported at node NH.
→ Step 3: Compute the bond’s value one year from now. This value is
determined as follows:
→ 3a. The bond’s value two years from now must be determined.
→ 3b. Calculate the present value of the bond’s value found in 3a using the
higher rate. This value is VH.
→ 3c. Calculate the present value of the bond’s value found in 3a using the lower
rate. This value is VL.
→ 3d. Add the coupon to VH and VL to get the cash flow at NH and NL,
respectively.
→ 3e. Calculate the present value of the two values using the one-year forward
rate using r*, so we can compute: VH  C and VL  C .
1  r* 1  r*


→ Step 4: Calculate the average present value of the two cash flows in
step 3. This is the value at a node is 1 VH  C VL  C .

2 
 1  r* 1  r* 

→ Step 5: Compare the value in step 4 with the bond’s market value. If the
two values are the same, the r1 used in this trial is the one we seek. This is
the one-year forward rate that would be used in the binomial interest-rate
tree for the lower rate, and the corresponding rate would be for the higher
rate. If, instead, the value found in step 4 is not equal to the market value
of the bond, this means that the value r1 in this trial is not the one-period
forward rate that is consistent with (1) the volatility assumption of 10%,
(2) the process assumed to generate the one-year forward rate, and
(3) the observed market value of the bond. In this case the five steps are
repeated with a different value for r1. [Note. If we get a value less than
$100, then the value for r1 is too large and the five steps must be
repeated, trying a lower value for r1.]
→ In this example, when r1 is 4.5% we get a value of $99.567 in step 4,
which is less than the observed market value of $100.Therefore, 4.5% is
too large and the five steps must be repeated, trying a lower value for r1.


→ After we compute r1, we are still not done. Suppose that we
want to “grow” this tree for one more year—that is, we want to
determine r2. Now we will use the three-year on-the-run issue
to get r2. The same five steps are used in an iterative process
to find the one-year forward rate two years from now. But now
our objective is as follows: Find the value for r2 that will
produce an average present value at node NH equal to the
bond value at that node and will also produce an average
present value at node NL equal to the bond value at that node.
When this value is found, we know that given the forward rate
we found for r1, the bond’s value at the root—the value of
ultimate interest to us—will be the observed market price. The
binomial interest-rate tree constructed is said to be an
arbitrage-free tree. It is so named because it fairly prices the
on-the-run issues.

Exhibit 17-10 Finding the One-Year Forward
Rates for Year 1 Using the Two-Year 4%
On-the-Run: First Trial
V = 100
C = 4.00
V = 98.582 r2,HH = ?
C = 4.00 NHH
NH r1,H = 5.496%
V = 99.567
C=0 V = 100
r0 = 3.500% C = 4.00
N r2,HL = ?
NHL
V = 99.522
C = 4.00
r1,L = 4.500%
NL V = 100
C = 4.00
r2,LL = ?
NLL

Exhibit 17-11 One-Year Forward Rates
for Year 1 Using the Two-Year 4%
On-the-Run Issue
V = 100
C = 4.00
V = 99.070 r2,HH = ?
C = 4.00 NHH
r1,H = 4.976%
NH
V = 100
C=0 V = 100
r0 = 3.500% C = 4.00
N NHL r2,HL = ?
V = 99.929
C = 4.00
r1,L = 4.074%
NL V = 100
C = 4.00
NLL r2,LL = ?

 Application to Valuing an Option-Free Bond

o To illustrate how to use the binomial interest-rate tree, consider
a 5.25% corporate bond that has two years remaining to
maturity and is option-free.
o Also assume that the issuer’s on-the-run yield curve is the one
given earlier, and hence the appropriate binomial interest-rate
tree is the one in Exhibit 17-12 (see Overhead 17-42).
o Exhibit 17-13 (see Overhead 17-43) shows the various values in
the discounting process and produces a bond value of $102.075.
o It is important to note that this value is identical to the bond
value found earlier when we discounted at either the
zero-coupon rates or the one-year forward rates.
o We should expect to find this result because our bond is option
free. This clearly demonstrates that the valuation model is
consistent with the standard valuation model for an option-free
bond.

Exhibit 17-12 One-Year Forward Rates for
Year 2 Using the Two-Year 4.5%
On-the-Run Issue
V = 97.886
C = 4.50
V = 98.074 r2,HH = 6.757%
C = 4.50 NHH
r1,H = 4.976%
NH
V = 100
C=0 V = 100
r0 = 3.500% C = 4.50
N NHL r2,HL = 5.532%
V = 99.926
C = 4.50
r1,L = 4.074%
NL V = 99.972
C = 4.50
r2,LL = 4.530%
NLL

Exhibit 17-13 Valuing an Option-Free
Corporate Bond with Three Years to
Maturity and a Coupon Rate of 5.25%
V = 97.886
C = 4.50
V = 98.074 r2,HH = 6.757%
C = 4.50 NHH
r1,H = 4.976%
NH
V = 100
C=0 V = 100
r0 = 3.500% C = 4.50
N NHL r2,HL = 5.532%
V = 99.926
C = 4.50
r1,L = 4.074%
NL V = 99.972
C = 4.50
r2,LL = 4.530%
NLL

 Valuing a Callable Corporate Bond

o The valuation process for a callable corporate bond
proceeds in the same fashion as in the case of an
option-free bond but with one exception:
• When the call option may be exercised by the issuer,
the bond value at a node must be changed to reflect
the lesser of its value if it is not called (i.e., the value
obtained by applying the recursive valuation formula
described previously) and the call price.
o For example, consider a 5.25% corporate bond with three
years remaining to maturity that is callable in one year
at $100.
• Exhibit 17-14 (see Overhead 17-45) shows the values
at each node of the binomial interest-rate tree.

Exhibit 17-14 Valuing a Callable Corporate Bond
with Three Years to Maturity and a Coupon Rate
of 5.25%, and Callable in One Year at 100
V = 98.588
C = 5.25
V = 99.461 r2,HH = 6.757%
C = 5.25 NHH
r1,H = 4.976%
NH
V = 101.432
C=0 V = 99.732
r0 = 3.500% C = 5.25
N NHL r2,HL = 5.532%
V = 100 (100.001)
C = 5.25
r1,L = 4.074%
NL V =100 (100.689)
C = 5.25
r2,LL = 4.530%
NLL

 Impact of Expected Interest Rate Volatility on Price

o Expected interest rate volatility is a key input into the valuation of
bonds with embedded options. To see the impact on the price of a
callable bond, Exhibit 17-15 (see Overhead 17-47) shows the price
of four 5%, 10-year callable bonds with different deferred call
structures (six months, two year, five years, and seven years)
based on different assumptions about the expected volatility of
short-term interest rates. We observe the following from the
exhibit:
1) The price of the option-free bond is the same regardless of the
interest rate volatility assumed. This is expected since there is
no embedded option that is affected by interest rate volatility.
2) For any given level of interest rate volatility, the longer the
deferred call, the higher the price. Again, as expected the
value of the option-free bond has the highest price.
3) The price of a callable bond moves inversely to the interest
rate volatility assumed.

Exhibit 17-15 Effect of Interest Rate
Volatility and Years to Call on Prices of 5%,
10-Year Callable Bonds
109
107
105
Price (%)
103
101
99
97
12 14 16 18 20 22 24 26 28 30
Volatility of Short-Term Interest Rate (%)

 Determining the Call Option Value (or Option Cost)

o The value of a callable bond is expressed as the difference
between the value of a noncallable bond and the value of
the call option.
o This relationship can also be expressed as follows:
value of a call option =
value of a noncallable bond – value of a callable bond
o But we have just seen how the value of a noncallable bond
and the value of a callable bond can be determined.
o The difference between the two values is therefore the
value of the call option.
o In our previous illustration, the value of the noncallable
bond is $102.075 and the value of the callable bond is
$101.432, so the value of the call option is $0.643.

 Extension to Other Embedded Options

o The bond valuation framework presented here can be used
to analyze other embedded options, such as put options,
caps and floors on floating-rate notes, and the optional
accelerated redemption granted to an issuer in fulfilling its
sinking fund requirement.
o Exhibit 17-16 (see Overhead 17-50) shows the binomial
interest-rate tree with the bond values altered at two nodes.
o Because the value of a non-putable bond can be expressed
as the value of a putable bond minus the value of a put
option on that bond, this means that
value of a put option =
value of a non-putable bond – value of a putable bond

Exhibit 17-16 Valuing a Putable Corporate Bond
with Three Years to Maturity and a Coupon Rate
of 5.25%, and Putable in One Year at 100
V = 100 (98.588)
C = 5.25
V = 100.261 r2,HH = 6.757%
C = 5.25 NHH
r1,H = 4.976%
NH
V = 102.523
C=0 V = 100 (99.732)
r0 = 3.500% C = 5.25
N NHL r2,HL = 5.532%
V = 101.461
C = 5.25
r1,L = 4.074%
NL V =100.689
C = 5.25
r2,LL = 4.530%
NLL

 Incorporating Default Risk

o The basic binomial model explained above can be extended to
incorporate default risk.
o The extension involves adjusting the expected cash flows for the
probability of a payment default and the expected amount of cash that
will be recovered when a default occurs.
 Modeling Risk
o The user of any valuation model is exposed to modeling risk.
o This is the risk that the output of the model is incorrect because the
assumptions upon which it is based are incorrect.
 Implementation Challenge
o To transform the basic interest rate tree into a practical tool requires
refinements.
• For example, the spacing of the node lines in the tree must be
much finer.
• While one can introduce time-dependent node spacing, caution is
required; it is easy to distort the term structure of volatility.
• Other practical difficulties include the management of cash flows
that fall between two node lines.

Option-Adjusted Spread
 The option-adjusted spread (OAS) was developed

as a measure of the yield spread (in basis points)
that can be used to convert dollar differences
between value and price.
 Thus, basically, the OAS is used to reconcile value
with market price.
 The OAS is a spread over the spot rate curve or
benchmark used in the valuation.
 The reason that the resulting spread is referred to
as option-adjusted is because the cash flows of the
security whose value we seek are adjusted to
reflect the embedded option.

Option-Adjusted Spread (continued)
 Translating OAS to Theoretical Value

o Although the product of a valuation model is the OAS,
the process can be worked in reverse.
o For a specified OAS, the valuation model can
determine the theoretical value of the security that is
consistent with that OAS.
o As with the theoretical value, the OAS is affected by
the assumed interest rate volatility.
o The higher (lower) the expected interest rate volatility,
the lower (higher) the OAS.
 Determining the Option Value in Spread Terms
o The option value in spread terms is determined as
follows:
option value (in basis points) = static spread – OAS

Effective Duration and Convexity
 There is a duration measure that is more appropriate

for bonds with embedded options that the modified
duration measure.
 In general, the duration for any bond can be
approximated as follows:
P_  P
duration 
   dy 
2 P0
P_ = price if yield is decreased by x basis points

P+ = price if yield is increased by x basis points
P0 = initial price (per $100 of par value)
∆y (or dy) = change in rate used to calculate price
(x basis points in decimal form)

Effective Duration and Convexity
(continued)
 When the approximate duration formula is applied to a

bond with an embedded option, the new prices at the
higher and lower yield levels should reflect the value
from the valuation model.
 Duration calculated in this way is called effective
duration or option-adjusted duration.
 The differences between modified duration and effective
duration are summarized in Exhibit 17-17 (see Overhead
17-56).
 The standard convexity measure may be inappropriate
for a bond with embedded options because it does not
consider the effect of a change in interest rates on the
bond’s cash flow.

Exhibit 17-17 Modified Duration Versus
Effective Duration
Duration
Interpretation: Generic description of the sensitivity of a bond’s price
(as a percent of initial price) to a parallel shift in the yield curve
Modified Duration Effective Duration

Duration measure in which it is assumed Duration measure in which recognition
that yield changes do not change is given to the fact that yield changes may
the expected cash flow change the expected cash flow

Key Points
● The traditional yield spread approach fails to take three factors into
account: (1) the term structure of interest rates, (2) the options
embedded in the bond, and (3) the expected volatility of interest
rates. The static spread measures the spread over the Treasury
spot rate curve assuming that interest rates will not change in the
future.
● The potential investor in a callable bond must be compensated for
the risk that the issuer will call the bond prior to the stated
maturity date. The two risks faced by a potential investor are
reinvestment risk and truncated price appreciation when yields
decline (i.e., negative convexity).
● The traditional methodology for valuing bonds with embedded
options relies on the yield to worst. The limitations of yield
numbers are now well recognized. Moreover, the traditional
methodology does not consider how future interest-rate volatility
will affect the value of the embedded option.

Key Points (continued)
● To value a bond with an embedded option, it is necessary to

understand that the bond can be decomposed into an
option-free component and an option component. The binomial
method can be used to value a bond with an embedded option.
It involves generating a binomial interest-rate tree based on
(1) an issuer’s yield curve, (2) an interest-rate model, and
(3) an assumed interest-rate volatility. The binomial
interest-rate tree provides the appropriate volatility-dependent
one-period forward rates that should be used to discount the
expected cash flows of a bond. Critical to the valuation process
is an assumption about expected interest-rate volatility.
● The OAS converts the cheapness or richness of a bond into a
spread over the future possible spot rate curves. The spread is
option adjusted because it allows for future interest-rate
volatility to affect the cash flows.

Key Points (continued)
● Modified duration and standard convexity, used to measure the

interest-rate sensitivity of an option-free bond, may be
inappropriate for a bond with an embedded option because
these measures assume that cash flows do not change as
interest rates change.
● The duration and convexity can be approximated for any bond,
whether it is option-free or a bond with an embedded option.
The approximation involves determining how the price of the
bond changes if interest rates go up or down by a small number
of basis points. If interest rates are changed and it is assumed
that the cash flows do not change, the resulting measures are
modified duration and standard convexity. However, when the
cash flows are allowed to change when interest rates change,
the resulting measures are called effective duration and effective
convexity.

Bonds With Embedded Options

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After reading this chapter, you will understand

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After reading this chapter, you will understand

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Issue Price Yield to Maturity (%)

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Present Value if Spread Used Is:

1 4.4 7.00000 4.2308 4.2287 4.2267

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Absolute Value of Percentage Price Change

-100 basis points X% Less than Y%

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Note: At y** yield level: PNCB = noncallable bond price

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o We can simplify the illustration by assuming annual-pay bonds. Using

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 Valuation of Option-Free Bonds

ii. The second way is to discount by the one-year forward rates:

$5.25 $5.25 $100 + $5.25

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 Introducing Interest-Rate Volatility

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Today 1 Year 2 Years 3 Years

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Today 1 Year 2 Years 3 Years

 Volatility and the Standard Deviation

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 Determining the Value at a Node

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 Constructing the Binomial Interest-Rate Tree

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 Constructing the Binomial Interest-Rate Tree

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 Constructing the Binomial Interest-Rate Tree

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 Constructing the Binomial Interest-Rate Tree

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 Application to Valuing an Option-Free Bond

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