Asset-Liability and Liquidity Management

CHAPTER 6Valuation of Bonds with Embedded Options

In Chapter 3 we introduced the discounted cash flow technique as the fundamental method for valuation of fixed-income securities. When cash flows of a bond at the valuation date are known, as is the case for a fixed-rate bond, the valuation is straightforward. For a floating-rate bond, future cash flows are not known at the present date but can be estimated using forecasted interest rates. Once the cash flows are estimated, the value of the bond can be obtained using the discounted cash flow method. An alternative approach in valuation of a floating-rate bond is to use the Monte Carlo simulation method, explained in a previous chapter. A callable or a putable bond has an embedded option that allows the issuer or the investor to terminate the bond earlier than its stated maturity, if certain conditions are met. Exercise of such an option can materially change the future cash flows and because of this the discounted cash flow method by itself is not a suitable valuation technique for bonds with embedded options. In this chapter we explain the use of the interest rate tree, introduced in the previous chapter, in valuation of callable and putable bonds.

CALLABLE BOND

A callable bond is a type of bond that is redeemable by the issuer prior to its maturity date. The issuer of a callable bond includes the call option in the structure of the note to protect against the risk of a fall in the interest rate. The issuer of a fixed-rate ...