FixedIncomeNotes

Reading43
;thediscountfactor
Number19onpage270!
Spotcurveshows,forvariousmaturities,theannualizedreturnonanoptionfreeanddefaultriskfreezero
couponbond.Avoidsthecomplicationsassociatedw/withtheneedforreinvestmentrateassumptions.
f(T*,T),T*=yearsfromtoday,T=yearsuntilmaturity.Ex:rateofatwoyearbondissuedinoneyear=F(1,2)
P(T*+T)=P(T*)F(T*,T)
F(T*,T)

Inanupwardyieldcurve,forwardratesincreaseasT*increases.Theylieabovethespotrates/
Inadownwardyieldcurve,forwardarebelowthespotrates.
TheparcurverepresentstheYTMoncouponpayinggovernmentbonds,pricedatpar,overarangeofmaturities.

Ontherun(recentlyissued)bondsareusuallyusedtocreatetheparcurve.Page228explainsbootstrapping!
TopictestAkron#2isreallygood.
Indevelopedmarkets,theyieldcurveflattensatlongermaturities.Becausenominalyieldsincorporateapremium
forexpectedinflation,anupwardslopingyieldcurveisgenerallyinterpretedasreflectingamarketexpectationof
increasingoratleastlevelfutureinflation.Theexistenceofriskpremiumsalsocontributestoapositiveslope.
Aninvertedyieldcurvemayreflectmarketexpectationsofdecliningfutureinflationrate,duetodeclining
economicactivity.
TheYTMistheexpectedrateofreturnforabondthatishelduntilmaturity,assumingthatallcouponandprincipal
paymentsaremadeinfullwhendueandthatcouponsarereinvestedattheoriginalYTM.TheYTMisthediscount
ratethat,whenappliedtoabondspromisedCFs,equatesthoseCFstothebondsmarketpriceandthefactthatthe
marketpriceshouldreflectdiscountingpromisedCFsatappropriatespotrate.
TheYTMcanbeapoorestimateofexpectedreturnif:1)interestratesarevolatile,2)theyieldcurveis
steeplysloped(upwardordownward),3)thereissignificantofdefault,or4)thebondhasoneormore
embeddedoptions.
TheYTMistheparrate.
Ifatraderexpectsthatthefuturespotratewillbelowerthanwhatispredictedbytheprevailingforwardrates,the
forwardcontractvalueisexpectedtoincrease.
Achangeintheforwardpriceistheresultofadeviationofthespotcurvefromwhatispredictedbytodays
forwardcurve.
Ifaninvestorsexpectedfuturespotrate<quotedforwardrate,thenthebondisundervalued,becausethemarket
iseffectivelydiscountingthebondspaymentsatahigherratethantheinvestoris,sothebondspriceisbelowits
intrinsicvalueperceivedbytheinvestor.
Ridingtheyieldcurveorrollingdowntheyieldcurve:buyingbondswithamaturitylongerthanthe
investmenthorizonwouldprovideagreatertotalreturnthanthereturnonamaturitymatchingstrategy.Thetotal
returnofthebondwilldependonthespreadbetweentheforwardrateandthespotrateaswellasmaturityofthe
bond.Thelongerthebondsmaturity,themoresensitiveitstotalreturnistospread.
Ifratesrisebymorethanpredictedbyforwardrates,thenthebondwilllosevalueasitispricedusing
higherrates.
Aforwardcontractpricewillincreaseifthefuturespotratesarelowerthanwhatispredictedbycurrentforward
rates.Thisisbecauseitisdiscountedataratethatislowerthantheoriginallyanticipatedrate.
Swaprate:theinterestrateforthefixedratelegofaninterestrateswap.Theleveloftheswaprateissuchthat
theswaphadzerovalueattheinitiationoftheswapagreement.
Swapcurve:yieldcurveofswaprates.Becauseitisbasedonsocalledparswaps,inwhichthefixedrates
aresetsothatnomoneyisexchangedatcontractinitiationthepresentvaluesofthefixedrateand
benchmarkfloatingrightlegbeingequaltheswapcurveisatypeofparcurve.
;s(T)=swaprateattimeT
Swapspread:spreadpaidbythefixedratepayerofaninterestrateswapovertherateoftheontherun
governmentsecuritywiththesamematurityastheswap.
Thehighertheswapspread,thehigherthereturnthatinvestorsrequireforcreditand/orliquidity
risks.
1

MAKESUREYOUKNOWHOWTOINTERPOLATE.Ex:youhaveabondthatmaturesin3.86years,
YTMfor3yearsis0.41andtheYTMfor4yearsis0.5.Theextrapolatedyieldwouldbe:
0.41+(3.863)(0.50.41)=0.4874.TopictestAkron#5.
Zspread:theconstantbasispointspreadthatwouldneedtobeaddedtotheimpliedspotyieldcurveso
thatthediscountedcashflowsofabondareequaltoitscurrentmarketprice.Thisspreadcanbemore
accuratethanalinearlyinterpolatedyield.Azspreadof100bpsforaparticularbondwouldimplythat
addingafixedspreadof100bpstothepointsalongthespotyieldcurvewillcorrectlypricethebond.A
higherzspreadimpliesariskierbond.Mostusefulforpricingacorporatebond.
ThequotingofthepriceofabondusingthebondyieldnetofeitherabenchmarkTreasuryyieldorswaprate
becomesapricequoteconvention.
SwapspreadtotheTreasuryratearesimplythedifferencesbetweenswapratesandgovernmentbondyieldsofa
particularmaturity.
Ispread:bondratesnetoftheswapratesofthesamematurities.
TEDspread:isanacronymforUSTbillandED,thetickersymbolfortheeurodollarfuturescontract.Itsan
indicatoroftheperceivedcreditriskinthegeneraleconomy.ItsthedifferencebetweenLiborandtheyieldonaT
billofmatchingmaturity.AnincreaseintheTEDspreadisasignthatlendersbelievetheriskofdefaulton
interbankloansisincreasing.
TheTEDspreadisNOTusedforindividualbonds.
LiborOISspread:differencebetweenLiborandtheovernightindexedswap(OIS)rate.AnOISisaninterestrate
swapinwhichtheperiodicfloatingrateoftheswapisequaltothegeometricaverageofanovernightrate(or
overnightindexrate)oververydayofthepaymentperiod.
TheLiborOISspreadincorporatesunsecuredlendingbetweenbanks.Itservesasagoodmeasureofthe
riskliquidityofmoneymarketsecurities.
Unbiasedexpectationstheoryorpureexpectationstheorysaysthattheforwardrateisanunbiasedpredictor
ofthefuturespotrate;itsbroadestinterpretationisthatbondsofanymaturityareperfectsubstitutesforone
another.Forexample,buyingabondwithamaturityof5yearsandholdingitfor3yearshasthesameexpected
returnasbuyinga3yearbondoraseriesof1yearbonds.Assertsthatdifferentmaturitystrategies,suchas
rollover,maturitymatching,andridingtheyieldcurve,havethesameexpectedreturn.
Hastheassumptionofriskneutrality,andthatinvestorsareunaffectedbyuncertaintyandriskpremiums
donotexist.
Localexpectationstheory:ratherthanassertingthateverymaturitystrategyhasthesameexpectedreturnover
agiveninvestmenthorizon,thistheoryinsteadcontendsthattheexpectedreturnforeverybondovershorttime
periodsistheriskfreerate.Althoughthetheoryrequiresthatriskpremiumsbenonexistentforveryshort
holdingperiod,nosuchrestrictionsareplacedonlongterminvestments.
Liquiditypreferencetheoryassuredthatliquiditypremiumsexisttocompensateinvestorsfortheadded
interestraterisktheyfacewhenlendinglongtermandthatthesepremiumsincreasewithmaturity.Thus,givenan
expectationofunchangingshorttermspotrates,liquiditypreferencetheorypredictsanupwardslopingyield
curve.Theforwardrateprovidesanestimateoftheexpectedspotratethatisbiasedupwardbytheamountofthe
liquiditypremium,whichinvalidatestheunbiasedexpectationstheory.Liquiditypreferencetheoryfailstooffera
completeexplanationofthetermstructure.Rather,itsimplyarguesfortheexistenceofliquiditypremiums.
Segmentedmarketstheoryallowsforlenderandborrowerpreferencestoinfluencetheshapeoftheyieldcurve.
Theresultisthatyieldsarenotareflectionofexpectedspotratesandliquiditypremiums.Rather,theyaresolelya
functionofthesupplyanddemandforfundsofaparticularmaturity.Thatis,eachmaturitysectorcanbethought
ofasasegmentedmarketinwhichyieldisdeterminedindependentlyfromtheyieldsthatprevailinothermaturity
segments.Contendsthatasset/liabilitymanagementconstraintsforceinvestorstobuysecuritieswhosematurities
matchthematuritiesoftheirliabilities.
Preferredhabitattheoryissimilartothesegmentedmarketstheoryinproposingthatmanyborrowersand
lendershavestrongpreferencesforparticularmaturitiesbutitdidnotassertthatyieldsatdifferentmaturitiesare
determinedindependentlyofeachother.Thepreferredhabitattheoryisbasedontherealisticnotionthatagents
andinstitutionswillacceptadditionalriskandreturnforadditionalexpectedreturns.Itassertsthatinvestorsare
willingtomoveawayfromtheirpreferredmaturityifthereisadequateincentivetodoso.
Equilibriumtermstructuremodelsshareseveralcharacteristics:
Theyareonefactorormultifactormodels:onefactormodelsassumethatasingleobservablefactordrive
allyieldcurvemovements.Multifactormodelsmaybeabletomodelthecurvatureofayieldcurvemore
accuratelybutatthecostofgreatercomplexity.
Theymakeassumptionsaboutthebehavioroffactors.
2

Theyare,ingeneral,moresparingwithrespecttothenumberofparametersthatmustbeestimated
comparedwitharbitragefreetermstructuremodels.
CoxIngersollRoss(CIR)model:assumingthatanindividualrequiresatermpremiumonthelongterm
rate,themodelshowsthattheshorttermratecandeterminetheentiretermstructureofinterestratesand
thevaluationofinterestratecontingentclaims.
dranddtrepresentaninfinitelysmallincrementintheshortterminterestrateandtime.
Themodelhastwoparts:1)adeterministicpart(sometimescalledthedriftterm)whichis
representedbydt,and2)astochastic(random)part,representedbydz,whichmodelsrisk.
Thewaythedeterministicpart,a(br)dt,isformulatedensuresmeanreversionofthe
interestratetowardalongrunvalueb,withthespeedofadjustmentgovernedbythe
strictlypositiveparametera.Ifaishigh,meanreversiontothelongrunratebwouldoccur
quickly.
Forsimplicity,wehaveassumedthetermpremiumfortheCIRmodeliszero.
Veryloosely,dzcanbethoughtofasaninfinitelysmallmovementinarandomwalk.The
stochasticorvolatilityterm,,followstherandomnormaldistributionsforwhichthe
meanest0,thestandarddeviationis1,andthestandarddeviationfactoris.Thestandard
deviationfactormakesvolatilityproportionaltothesquarerootoftheshorttermrate,
whichallowsforvolatilitytoincreasewiththelevelofinterestrates.Italsoavoidthe
possibilityofnonpositiveinterestratesforallpositivevaluesofaandb.
CIRmodelsassumesthatinterestratevolatilityincreaseswithincreaseswiththelevelof
interestrates.
Vasicekmodel:
UnliketheCIRmodel,interestratesarecalculatedassumingthatvolatilityremainsconstantover
theperiodofanalysis.
ThemaindisadvantageoftheVasicekmodelisthatitistheoreticallypossiblefortheinterestrate
tobecomenegative.
Assumesthatinterestvolatilityisaconstant.
Arbitragefreemodels:theanalysisbeginswiththeobservedmarketpriceofareferencesetoffinancial
instrumentsandtheunderlyingassumptionisthatthereferencesetiscorrectlypriced.
HoLeemodel:
Themodelcanbecalibratedtomarketdatabyinferringtheformofthetimedependentdriftterm,,
frommarketprices,whichmeansthemodelcanpreciselygeneratethecurrenttermstructure.
Thismodelisarbitragefreeandcanbecalibratedtocloselymatchtheobservedtermstructure.
Shapingrisk:definedasthesensitivityofabond'spricetothechangingshapeoftheyieldcurve.Theshapeofthe
yieldcurvechangescontinually,andyieldcurveshiftsarerarelyparallel.
Yieldcurvefactormodel:theyieldcurvecanbedescribedbythreeindependentmovements
Level:referstoanupwardordownwardshiftintheyieldcurve.Mostimportantvariable.
Steepness:referstoanonparallelshiftintheyieldcurvewheneithershorttermrateschangemorethan
thelongtermratesorviceversa.
Curvature:referstotomovementinthethreesegmentsoftheyieldcurve:theshorttermandlongterm
segmentsrisewillthemiddletermsegmentfallsorviceversa.
PrincipalComponentsAnalysis(PCA):focusesonidentifyingthefactorsthatbestexplainhistoricalvariancesin
theyieldcurve.PCAcreateanumberofsyntheticfactorsdefinedasstatisticallyindependentofeachother;how
thesefactorsmaybeinterpretedeconomicallyisachallengetotheresearcherthatcanbeaddressedbyrelating
movementsinthefactorstwomovementsinobservableandeasilyunderstoodvariables.
Thetermstructureofinterestratevolatilitiesisarepresentationoftheyieldvolatilityofazerocouponbondfor
everymaturityofsecurity.Thisvolatilitycurvemeasuresyieldcurverisk.
Onthebasisofthetypicalassumptionofalognormalmodel,theuncertaintyofaninterestrateismeasured
bytheannualizedstandarddeviationoftheproportionalchangeinabondyieldoveraspecifiedtime
interval.Thetermstructureofvolatilitiesisbelow:

Thevolatilitytermstructuretypicallyshowsthatshorttermratesaremorevolatilethanlongterm
rates.
Keyratedurationmeasuresasecurity'spricesensitivitytoshiftsat"key"pointsalongtheyieldcurve.
Tocalculate,considervariousyieldmovements.First,supposethattheoneyearratechangesby100bps
whiletheotherratesremainthesame;thesensitivityoftheportfoliotothatshiftis1/[(300)(0.01)]=
3

0.3333.Weconcludethatthekeyratedurationoftheportfoliototheoneyearrate,denotedD1,is0.3333.
Keyratedurationforthe5yearrateD5,and10yearrateD10.

=levelfactor
=steepnessfactor
=curvaturefactor
Iftheyieldcurvechangesparallely,thenthechangeinthevalueofthebond/portfolioistheeffective
duration.TopictestAkron#6.
Ifthesteepnesschanges,thentheloss=(% yieldxkeyratedurationxweight)
Rereadpages264266!
TopictestSeacrest#1.

Reading44
Arbitragefreevaluationreferstoanapproachtosecurityevaluationthatdeterminessecurityvaluesthatare
consistentwiththeabsenceofanarbitrageopportunity,whichisanopportunityfortradesthatearnriskless
profitswithoutanynetinvestmentofmoney.Inwellfunctioningmarkets,pricesadjustuntiltherearenoarbitrage
opportunities,whichistheprincipleofnoarbitragethatunderliesthepracticalvalidityofarbitragefree
valuation.Thisprincipleitselfcanbethoughtofasanimplicationoftheideathatidenticalassetsshouldsellatthe
sameprice.
ArbitragefreevaluationappliestoriskfreesecuritiesandportfoliosONLY.Valueadditivityandlackof
dominancemustholdforamarkettobearbitragefree.
Valueadditivity:thevalueofaportfoliomustequalthesumoftheindividualsecurities.
Lackofdominance:tworiskfreesecuritieswiththesametimeandamountofpayoffmustbethe
sameprice.
Inarbitragefreevaluation,thereisnorelationshipbetweenriskfreeandriskysecurities.
Stripping:adealersabilitytoseparateabondsindividualCFsandtradethemaszerocouponsecurities.
Reconstitution:dealerscanrecombinetheappropriateindividualzerocouponsecuritiesandreproducethe
underlyingcouponTreasury.
Goodexampleofbootstrappingonpage281,example2!Andquestion2onpage305.
Step1:calculateallthespotratesbyusingtheparrates:
Step2:discounttheCFofthebondusingeachspecificspotrateforthecorrectmaturity.
Forinteresttreemodel,twoassumptionsarerequired:1)aninterestratemodeland2)avolatilityofinterest
rates.Alognormalrandomwalkiscommonlyused,becauseithastwoappealingfeatures:1)nonnegativityof
interestratesand2)highervolatilityathigherinterestrates.Ateachnode,therearetwopossibleratesoneyear
forwardatTime1.

Thelowerofthetworates,iL,isonestandarddeviationbelowthemean(oneyearimpliedforward
rate)andiHisonestandarddeviationabovethemean.
and
Withasimple,lognormaldistribution,thechangesininterestratesareproportionaltotheleveloftheone
periodinterestrateseachperiod.Itcanbeshownthatforalognormaldistributionthestandarddeviation
oftheoneyearrateisequaltoi0 .Asaresult,interestratemovesarelargerwheninterestratesarehigh
andaresmallerwheninterestratesarelow.
Benefitsofalognormaldistributionisthatifinterestratesgettooclosetozero,theabsolutechange
becomessmallerandsmaller.
Youstartwithmaturity,andworkfromrighttolefttogetthepriceofthebond.
Therelevantdiscountratetouseistheoneyearforwardrateatthenode.Becausetherearetwopossible
interestratesoneyearfromtoday,therearetwopresentvalues.Taketheaverage.
Bondvalueatnode=;VH=bondvalueifthehigherforwardrateisrealizedoneyearhence,VL=bond
valueiflowerforwardrateisrealizedoneyearhence,C=couponpaymentthatisnotdependenton
interestrates.
Whenyougettoyear1,DONOTINCLUDETHECOUPON.Youwantjustthebondprice!
Makesuretopayattentiontowhenthebondmatures!TopictestDesna#4.
4

Thehigherthevolatility( ),themorespreadouttheforwardrateswillbe.Thelowerthe ,thetighterthe

forwardrateswillbe.Doexample4onpage293!
ThebinomialinterestratetreeshouldproducethesamevalueasdiscountingtheCFswiththespotrates.
Anoptionfreebondthatisvaluedbyusingthebinomialinterestratetreeshouldhavethesamevalueas
discountingbythespotrates,whichistruebecausethebinomialinterestratetreeisarbitragefree.
Pathwisevaluationcalculatesthepresentvalueofabondforeachpossibleinterestratepathandtakesthe
averageofthesevaluesacrossthepaths.Itinvolvesthefollowingsteps:1)specifyalistofallpotentialpaths
throughthetree,2)determinethepresentvalueofabondalongeachpotentialpath,and3)calculatetheaverage
acrossallpossiblepaths.
Howtogetthenumberofinterestratepaths:a4yearbondrequires23=8paths.
TheMonteCarlomethodisanalternativemethodforsimulatingasufficientlylargenumberofpotentialinterest
ratepathsinanefforttodiscoverhowthevalueofasecurityisaffected.
Increasingthenumberofpathsincreasestheaccuracyoftheestimateinastatisticalsense.ItdoesNOT
meanthemodelisclosertothetruefundamentalvalueofthesecurity.
MonteCarlosimulationmustbecalibratedwithaconstant,calledthedriftterm.
MonteCarlosimulationsaremainlyusedcashflowsarepathdependent.
Cashflowsarepathdependentwhenthecashflowtobereceivedinaparticularperioddependson
thepathfollowedtoreachitscurrentlevelaswellasthecurrentlevelitself.Forexample,MBs
valuationsdependstoagreatextentonthelevelofprepayments,whichareinterestratepath
dependent.
TheMonteCarloapproachrandomlysimulatesafixednumberofinterestratepathsandvaluesthe
securityonlyacrossthosepaths,whereasthebinomialtreeapproachvaluesofthesecurityacrossall
possibleinterestratepassonthetree.
Calibratingabinomialinterestratetreetomatchaspecifictermstructureisimportantbecausewecanusethe
knownvaluationofabenchmarkbondfromthespotratepricingtoverifytheaccuracyoftheratesshowninthe
binomialinterestratetree.Onceitsaccuracyisconfirmed,theinterestratetreecanthenbeusedtovaluebonds
withembeddedoptions.Whilediscountingwithspotrateswillproducearbitragefreevaluationsforoptionfree
bonds,thisspotratemethoditwillnotworkforbondswithembeddedoptionswhereexpectedfuturecashflows
areinterestratedependent.Theinterestratetreeallowsforthealternativepathsthatabondwithembedded
optionsmighttake.

Reading45
Acalloptionallowstheissuertobenefitfromlowerinterestratesbyretiringthebondissueearlyandrefinancing
atthelowerrate.
Today,investorsshouldhavenofearofreceivinglessthantheirbondsworth,iftheyarecalled.
Lockoutperiod:aperiodwhentheissuercantcallthebond.
Europeanstyle:onlycallableonasingledateattheendofthelockoutperiod.
Americanstyle:continuouslycallablefromtheendofthelockoutperioduntilthematuritydate.
Bermudanstyle:canbeexercisedonlyonapredeterminedscheduleofdatesaftertheendofthelockout
period.
Inacallablebond,theownerislongthebondandshorttheoption.
Valueofcallablebond=valueofstraightbondvalueofissuercalloption.
Ifthevalueofthebondislowerthanthecallprice,theissuerwillnotcallthebond.
Ifinterestratesdecline,thevalueofthecallablebondwillriselessthanthestraightbond.Thevalueofthe
calloptionincreasesasratesdecline,butsincethecalloptionissubtractedoutofthestraightbondtoget
thecallablebondvalue,thisoffsetthegains.
Thevalueofthecalloptionincreasesastheyieldcurveflattens.Thisisbecausewhentheyieldcurve
flattens,manynodesonthetreehavelowerforwardrates,thusincreasingtheopportunitiestocall.
Ifthevalueisabove100,itwillbecalled,BUTDOUBLECHECKTHEDATESOFWHENITISCALLABLE.
AputoptionallowsthebondholdertobenefitfromhigherinterestratesbyputtingbacktheBoss2theissuerand
reinvestingtheproceedsoftheretiredBondatahigheryield.
Extensionoption:atypeofputoption,wheretheholderhastherighttoextendthematurity,possiblywith
adifferentcoupon.
Sinkingfundbond:requirestheissuertosetasidefundsovertimetoretirethebondissue,thusreducing
creditrisk.
Inaputablebond,theownerislongthebondandlongtheoption.
5

 Valueofputablebond=valueofstraightbond+valueofinvestorputoption
Ifinterestratesrise,thevalueofthestraightbonddeclinesbutthevalueoftheputoptionincreases,
offsettingsomeofthelosses.Ifratesarerising,aputablebonddeclineslessthanastraightbond.
Thevalueoftheputoptiondecreasesastheyieldcurveflattensorinverts.
Ifthevalueisbelow100atacertainnode,itwillbeput.BUTDOUBLECHECKTHEDATESOFWHENITIS
PUTABLE.
Abondthatiscallableandputableisworthmorethanabondthatisjustcallable.
Thevalueofanyembeddedoption,regardlessofthetypeofoption,increaseswithinterestratevolatility.The
greaterthevolatility,themoreopportunitiesexistfortheembeddedoptiontobeexercised.
Higherdiscountratesimplylowerpresentvalues,andthusthevalueofariskybondwillbelowerthanthatofan
otherwiseidenticaldefaultfreebond.
Tovalueriskystraightbonds,youshouldraisetheoneyearforwardratesderivedfromthedefaultfree
benchmarkyieldcurvebyafixedspread,whichisestimatedfromthemarketpricesofsuitablebondsofsimilar
quality.Thisfixedspreadisknownasthezerovolatilityspread,orZspread.
Thesamecanbedoneforbondswithembeddedoptions.Inthiscase,theoptionadjustedspread(OAS)
isused.TheOASistheconstantspreadthat,whenaddedtoalltheoneperiodforwardratesontheinterest
ratetree,makesthearbitragefreevalueofthebondequaltoitsmarketprice.
AnOASlowerthanthatforabondwithsimilarcharacteristicsandcreditqualityindicatesthatthe
bondislikelyoverpriced(rich)andshouldbeavoided.AlargerOASthanthatofabondwithsimilar
characteristicsandcreditqualitymeansthatthebondislikelyunderpriced(cheap)
Ifinterestratevolatilityincreases,theOASforabondwilldecrease.
Effectivedurationindicatesthesensitivityofthebondspricetoa100bpsparallelshiftinthebenchmarkyield
curveinparticularthegovernmentparcurveassumingnochangeinthebondscreditspread.Assumesaparallel
shiftacrosstheyieldcurve.
Effectiveduration=
Theeffectivedurationofacallable/putablebondcannotexceedthatofastraightbond.
Whenratesarehigh,thecalloptionisoutofthemoney,andchangesininterestrateshavethesame
effectonbothoptionfreeandcallablebonds.Butasratesfall,theoptionmovesintothemoney,
whichlimitsthepriceappreciationwhenratesdecline.Asaconsequence,thecalloptionreduces
theeffectivedurationofthecallablebondrelativetothestraightbond.
Whenratesarelow,theputoptionisoutofthemoney,andinterestratechangeshavesimilar
effectsonbothstraightbondsandputablebonds.Asratesrise,theputoptionmovesintothe
moneyandlimitsthepricedepreciationbecausetheinvestorcanputthebondandreinvestthe
proceedsatahigherrate.Thus,theputoptionreducestheeffectivedurationoftheputablebond
relativetothatofastraightbond.
Aputablebondhaslimiteddownsidepotential,andacallablebondhaslimitedupsidepotentialThus,theprice
sensitivityofbondswithembeddedoptionsisnotsymmetricaltopositiveandnegativechangesininterestratesof
thesamemagnitude.
Nomatterhowfarratesfall,acallablebondspricecantexceed100becausenoinvestorwillpaymore
thanthatforabondthatcanbeimmediatelycalled.Butthereisnolimitifratesrise.
Onesideddurationsshowtheeffectivedurationsforacallable/putablebondwhenratesgoupordown.
Itsbetteratcapturingtheinterestratesensitive,especiallywhentheoptionsarenearthemoney.
Keyratedurations:reflectsthesensitivityofthebondspricetochangesinspecificmaturitiesonthebenchmark
yieldcurve.Thus,keyratedurationhelpsportfoliomanagersidentifytheshapingriskforbondsthatis,thebonds
sensitivitytochangesintheshapeoftheyieldcurve.
Changingthekeyratedurationthatmatchesthematuritywillhavethegreatesteffective,sincethisis
wherethelargestcashflowis.Graphonpage347isgood.Thegraphalsoappliestoconvexity.
Effectiveconvexitymeasuresthesensitivityofdurationtochangesininterestrates
Effectiveconvexity
Optionfreebondsexhibitlowpositiveconvexitythepriceofanoptionfreebondrisesslightlymorewhen
ratesmovedownthanitdeclineswhenratesmoveupbythesameamount.
Whenratesarehighandthevalueofthecalloptionislow,thecallableandstraightbondexperiencevery
similareffects.However,effectiveturnsnegativewhenthecalloptionisnearthemoney,whichindicates
thattheupsideforacallablebondismuchsmallerthanthedownside.Thereasonisbecausewhenrates
decline,thepriceofthecallablebondiscappedbythepriceofthecalloptionifitisneartheexercisedate.

Putablebondsalwayshavepositiveconvexity.Whentheoptionisnearthemoney,theupsideforaputable
bondismuchlargerthanthedownsidebecausethepriceofaportablebondisflooredbythepriceofthe
putoptionifitisneartheexercisedate.
Iftheyieldcurveflattensbuttheinterestratevolatilitystaysthesame,thecallableandputablebondwillbothrise,
butlessrapidlythanthestraightbond.
Cappedfloater:protectstheissueragainstrisinginterestratesandisthusanissueroption.Theinvestorislong
thebondbutshorttheoption.
Valueofcappedfloater=valueofstraightbondvalueofembeddedcap
Ifthecouponissetinarrears,thismeansthatthecouponrateissetatthebeginningofthecouponperiod
thatis,thecoupontobepaidinoneyearisdeterminednow.
Ifthecaprateishigherthananyoftheratesgiven,thevalueofthecappedfloateris100.Ifthecaprateis
lowerthantheinterestrate,thevaluewillbebelowzero.
BeVERYcarefulaboutwhichratesyoureusing,andwhichcoupongoeswhere!
Flooredfloater:protectstheinvestoragainstdeclininginterestratesandisthusaninvestoroption.Investoris
longthebondandlongtheoption.
Valueofflooredfloater=valueofstraightbond+valueofembeddedfloor.
Ifthefloorrateislowerthantheinterestrate,thevalueoftheflooredfloateris100.Ifthefloorrateis
higherthantheinterestrate,thevalueoftheflooredfloatingbondwillgreaterthan100.
Theeffectivedurationofafloatingratebondisclosetothetimetonextreset.
Theeffectivedurationofanoptionfreebondchangesverylittleinresponsetointerestratemovements.Asrates
rise,acalloptionmovesoutofthemoney,whichincreasesthevalueofthethecallablebondandlengthensits
effectiveduration.Asinterestratesrise,aputoptionmovesintothemoney,whichlimitsthepricedepreciationof
theputablebondandshortensitseffectiveduration.
Investorsusuallyacceptalowercouponforconvertiblebondsthanforotherwisenonconvertiblebondsbecause
theycanparticipateinthepotentialupsidethroughtheconversionmechanismthatis,ifthesharepriceofthe
issuer'scommonstockexceedstheconversionprice,thebondholdercanconvertthebondsintosharesatacost
lowerthanmarketvalue.Theissuerbenefitsfromalowercoupon.Anaddedbenefitfortheissueristhatitno
longerhastorepaythedebtthatwasconvertedintoequity.
Iftheconvertiblebondisneverconverted,thebondholdermissedoutonadditionalyieldbecauseofthe
lowercouponontheconvertiblebond.
Conversionratio:thenumberofsharesofcommonstockthebondholderreceives.
Amountofdebt/conversionprice
Conversionprice=parvalue/conversionratio
Somefirmsofferdividendprotectionbyadjustingtheconversionpricedownwardwhendividendsare
aboveapredefinedthreshold.
Inachangeofcontrolevent,bondholdersmaynolongerwanttolendtothefirm.Bondholdersusually
havetwochoices:
1)aputoptionthatcanbeexercisedduringaspecifiedperiodfollowingthechangeofcontroleven.
Hardput:issuermustredeemtheconvertiblebondforcash
Softput:theissuerchooseshowthepaymentwillbe.
2)theconversionpriceisadjusteddownward
Ifaconvertiblebondiscallable,theissuerhasanincentivetocallthebondwhentheunderlyingshare
priceincreasesabovetheconversionpriceinordertoavoidpayingfortheircoupons.Thisiscalleda
forcedconversion.
Theforcedconversionstrengthenstheissuerscapitalstructureandeliminatestheriskthata
subsequentcorrectioninequitypricespreventconversionandrequiresredeemingtheconvertible
bondsatmaturity.
Conversionvalue=underlyingsharepricexconversionratio
Minimumvalueofaconvertiblebondisthegreaterof:1)theconversionvalue,or2)thevalueofunderlying
optionfreebond.
Marketconversionpremiumpershareallowsinvestorstoidentifythepremiumordiscountpayable
whenbuyingtheconvertiblebondratherthantheunderlyingcommonstock.
Marketconversionpremiumpershare=marketconversionpriceunderlyingshareprice
Marketconversionprice=convertiblebondprice/conversionratio
Oncethemarketvalueofthestockishigherthantheconversionprice,anyfurtherincreaseinshare
pricewillincreasethevalueoftheconvertiblebond.
7

Marketconversionpremiumratioexpressesthepremiumordiscountinvestorshavetopayasa
percentageofthecurrentmarketpriceoftheshares
Marketconversionpremiumratio=marketconversionpremiumpershare/shareprice
Marketconversionpremiumpershare=(bondprice/conversionratio)marketstockprice.
Whywouldsomeonepayapremiumforaconvertiblebond?Becausethemostaconvertible
bondholdercanloseisthedifferencebetweentheconvertiblebondpriceandthestraight
valuebecausethestraightvalueisnotfixed.Thestraightvalueactsasafloorforthe
convertiblebondprice.
Premiumoverstraightvalue=(convertiblebondprice/straightvalue)1
Valueofconvertiblebond=valueofstraightbond+valueofcalloptionontheissuersstock.
Valueofcallableconvertiblebond=valueofstraightbond+valueofcalloptionontheissuersstockvalue
ofissuercalloption
Valueofcallableputableconvertiblebond=valueofstraightbond+valueofcalloptionontheissuers
stockvalueofissuercalloption+valueofinvestorputoption.
Bustedconvertible:whenthesharepriceisbelowtheconversionprice.Exhibitsmostlybondlike
characteristics.
Whenthesharepriceisabovetheconversionprice,theconvertiblebondwillexhibitmostlystock
likecharacteristics.However,ittheconvertiblebondwillstillfluctuateslightlylessthanthe
commonstock.
Ifthesharepriceisbelowtheconversionprice,thebondwillexhibitmostlybondlike
characteristics.Page369hasagoodchart!
Putcallparity:value(C)value(P)=PV(Forwardpriceofbondonexercisedateexerciseprice)

Reading46
Probabilityofdefault:obviouslythehighertheprobability,theriskierthebond.
Lossgivendefault:theamountofcouponandprincipalpaymentslostintheeventofdefault.Usuallyexpressedas
apercentage.
Recoveryrate:percentageofthepositionreceivedorrecoveredindefault.
Expectedloss=probabilityofdefaultxlossgivendefault.
Presentvalueoftheexpectedlossisconceptuallythelargestpriceonewouldwouldbewillingtopayonabond
toathirdpartytoentirelyremovethecreditriskofpurchasingandholdingthebond.Outofalloftheabove,this
measureismostimportant,buthardesttocalculate.
Creditscoresareanordinalrankingbecauseitonlyorderstheborrowersriskinessfromhighesttolowest.It
doesnttellyouifborrowerAistwiceasriskyasborrowerB,acardinalranking.
Creditratings:rankThecreditriskofacompany,government,orABS.Creditratingsdonotprovideanestimate
oftheloansdefaultprobability.
Manyratingagencieshaveanissuerpaysmodel,whichisaconflictofinterest.
Creditratingsdonotchangewiththebusinesscycleandagenciesaremotivatedtomaintainstabilityin
theirratingsovertimetoreducedebtmarketvolatility.
Internalratings:heavilyusedbyfinancialinstitutionstocontroltheircreditrisk.
Structuralmodelswereoriginatedtounderstandtheeconomicsofacompany'sliabilitiesandbuildontheinside
ofoptionpricingtheory.They'recalledstructuralmodelsbecausetheyarebasedonthestructureofacompany's
balancesheet.Thismodelassumesthatthecompanysassetstrade.
Optionanalogy:thecompany'sequityhasthesamepayoffasaEuropeancalloptiononthecompany's
assetswithastrikepriceKandmaturityT.Equityholderswillpayoffdebtonlyifthevalueoftheassetsat
timeTexceedswhatisowedthatis.Afterthepayment,theykeepwhatsleftover(ATK).If,thenthe
equityholderswilldefault.Owningthecompanysdebtiseconomicallyequivalenttoowningariskless
withbondthatpaysKwithcertaintyattimeT,andsimultaneouslysellingaEuropeanputontheassetsof
thecompanywithstrikepriceKinmaturityT.Thedebtanalogyexplainswhyriskydeadislessvaluable
thanrisklessdebt.Thedifferenceinvalueisequaltotheshortputoptionsprice.Inessence,thedebt
holderslendtheequityholdersKdollarsandsimultaneouslysellthemaninsurancepolicyforKdollarson
thevalueoftheirassets.
EquityisviewedasaEuropeancalloptiononthecompanysassetswithaspecificmaturityand
strikeprice,andtheprobabilityofdefaultisequaltotheprobabilitythatthecompanysassetvalue
fallsbelowthefacevalueofthedebtandthelossgivendefaultisgivenbythisshortfall.
Strengthofthestructuralmodel:thestructuralmodelcanbeestimatedusingcurrentmarketprices
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Weaknesses:1)Itscreditriskmeasurescanbeestimatedonlybyusingimplicitestimationprocedures
becausethecompany'sassetvalueisunobservable,2)itscreditriskmeasuresarebiasedbecauseimplicit
estimationproceduresinherenterrorsinthemodelsformulation,and3)thecreditriskmeasuresdonot
explicitlyconsiderthebusinesscycle.
Assumesthattheriskfreerateofreturnisconstantovertimeandthevalueofthecompanysassetshavea
lognormaldistribution.
Reducedformmodelswereoriginatedtoovercomeaweaknessofthestructuralmodeltheassumptionthatthe
company'sassetstrade.Onlyassumesthatsomeoftheassetstrade.
Defaultintensitygivestheprobabilityofdefaultoverthenextinstant[t,t+ ]whentheeconomyisinstate
Xt.
Unlikethestructuralmodel,thecompany'sprobabilityofdefaultdoesnotexplicitlydependonthe
company'sbalancesheet.Thesamedefaultprobabilityappliestoallofthecompany'sliabilitiesbecauseof
theexistenceofcrossdefaultclausesandcorporatedebt.Intheeventofdefault,reducedformmodels
allowthecompanysdifferentliabilitiestohavedifferentlossrates.Thesearesignificantadvantagesof
usingareducedformmodel.
Historicalestimatecanbeusedforareducedformmodel,becausetheeconomysmacroeconomicsstate
variablesandthecompany'sdebtpricesarebothobservable.
Estimatingareducedformmodelsparametersusinghistoricalestimationisinanapplicationofhazard
rateestimation.Hazardrateestimationisatechniqueforestimatingtheprobabilityofabinaryevent,like
adefault/nodefault,mortality/nomortality,carcrash/nocarcrash,etc.
Reducedformstrengths:1)themodelsinputsareobservable,sohistoricalestimationprocedurescanbe
usedforthecreditriskmeasures,2)themodelscreditriskmeasuresreflectthechangingbusinesscycle,
and3)themodeldoesnotrequireaspecificationofthecompany'sbalancesheetstructure.
Reducedformweakness:Hazardrateestimationproceduresusepastobservationstopredictthefuture.
Forthistobevalid,themodelmustbeproperlyformulatedandbacktested.
Presentvalueofexpectedlossduetocreditrisk=PVcorporatePVtreasury.TopictestFalmouth#6.
Areducedformmodelrequiresthatoneofthecompany'sliabilitiestrade;itcanbeazerocouponbondor
andestimationofzerocouponbondsfromobservableriskycouponbondpricesthattrade.Inaddition,the
company'sdefaultprospectsaredependentonmacroeconomicstatevariables.Theseexplanatory
variablescanincludesuchinputsasthegrowthrateofGDPandthelevelofunemployment.Themodelalso
requiresariskfreerate.
Defaultprobabilitiesandlossgivendefaultcanbemodeledasafunctionofthestateoftheeconomy,but
whetherthecompanyactuallydefaultsisanidiosyncraticrisk.
Reducedformmodelsvalueriskycorporatedebtbyusingriskneutralprobabilityandariskfreerateof
interestthatisstochastic(randomlydetermined).
TopictestSeacrest#6.WholetopictestFalmouth.

Criteria

Structural

ReducedForm

Requiresspecificationof
companysbalancesheet

Yes=weakness

No=strength

Assumesassetstradein
liquidmarket

Yes=weakness

No=strength

Typeofinputdata

Currentmarket=strength

Historical=weakness

Creditratingsaretheleastaccuratepredictors.Thisisbecausecreditratingstendtolagchangesinadebtissues
creditriskbecauseofratingagenciesdesiretokeepratingsrelativelystableovertime,andconsequently,theyare
relativelyinsensitivetochangesinthebusinesscycle.
Reducedformmodelsperformbetterthanstructuralmodelsbecausestructuralmodelsarecomputedusing
implicitestimationprocedureswhereasreducedformmodelsarecomputedusinghistoricalestimation(hazard
rateprocedure).Theperformanceisduetotheflexibilityofhazardrateestimationproceduresthatis,boththeir
abilitytoincorporatechangesinthebusinesscycleandtheirindependenceofaparticularmodelspecifyinga
company'sbalancesheetstructure.

Usingeitherthestructuralorreducedformmodel,underthefrictionlessmarketassumption,thecreditspreadis
entirelyduetocreditrisk.Toseethis,itiseasiesttousetheconstantdefaultprobabilityandlossgivendefault
formulas(onpage410).
AssetbackedsecuritiesOratypeofbondissuedbyalegalentitycalledaspecialpurposeentity(SPE)orspecial
purposevehicle(SPV).AnSPEisformedtoownthepoolofsecuritizedassetsfromwhichthecashflowswillbe
generated.ThepoolofsecuritizedassetsistypicallyreferredtoasthecollateralfortheABS.Thecollateralusually
consistsofacollectionofloansorreceivablesofaparticulartype.
AnSPEiscreatedbytheequityholders.Tofinancethepurchaseofthecollateral,theequityholdersissue
debt.ThestructureofthedebtforanSPEisdifferentfromthatoftypicalcorporatedebt.AnSPEsdebtis
issuedinvariousbondtranches.
Thecashflowsarefirstpaidtothemostseniorbondtranches,thentothenextsenior,andsoforth
untoallcouponpaymentsaremade.Anyresidualcashflowsgototheequityholders.Thelosses
duetothedefaultingloansgoinreverseorder.Anylossesarefirstcoveredbytheequityholders,
thentheleastseniorbondtranche,andsoforthuptothemostseniorbondtranche.Thisallocation
ofcashflowsandlossesiscalledthewaterfall.
Unlikecorporatedebt,anABSdoesnotgointodefaultwhenaninterestpaymentismissed.A
defaultinthepoolofsecuritizedassetsdoesnotcauseadefaulttoeithertheSPEorbondtranche.
ForanABS,thebondcontinuestotradeuntileitheritsmaturitydateorallofitsfacevalueis
eliminatedbecauseoftheaccumulatedlossesinthepoolofsecuritizedassetsorthroughearlyloan
payments.
ProbabilityofdefaultdoesNOTapplytoABSs.

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