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Callable Bond and Vaulation: Finpricing

This document discusses the valuation of callable bonds. It begins by defining callable bonds and outlining their advantages for both issuers and investors. It then discusses callable bond payoffs and the criteria for selecting valuation models, choosing the Linear Gaussian Model (LGM) and lattice approach. The document outlines the LGM assumptions and calibration process before detailing the valuation implementation using lattice-based backward induction. It concludes by providing an example specification of a real-world callable bond.

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51 views13 pages

Callable Bond and Vaulation: Finpricing

This document discusses the valuation of callable bonds. It begins by defining callable bonds and outlining their advantages for both issuers and investors. It then discusses callable bond payoffs and the criteria for selecting valuation models, choosing the Linear Gaussian Model (LGM) and lattice approach. The document outlines the LGM assumptions and calibration process before detailing the valuation implementation using lattice-based backward induction. It concludes by providing an example specification of a real-world callable bond.

Uploaded by

davelikesw007
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Callable Bond and

Vaulation

FinPricing
Callable Bond

Summary
◆ Callable Bond Definition
◆ The Advantages of Callable Bonds
◆ Callable Bond Payoffs
◆ Valuation Model Selection Criteria
◆ LGM Model
◆ LGM Assumption
◆ LGM calibration
◆ Valuation Implementation
◆ A real world example
Callable Bond

Callable Bond Definition


◆ A callable bond is a bond in which the issuer has the right to call the
bond at specified times (callable dates) from the investor for a specified
price (call price).
◆ At each callable date prior to the bond maturity, the issuer may recall
the bond from its investor by returning the investor’s money.
◆ The underlying bond can be a fixed rate bond or a floating rate bond.
◆ A callable bond can therefore be considered a vanilla underlying bond
with an embedded Bermudan style option.
◆ Callable bonds protect issuers. Therefore, a callable bond normally pays
the investor a higher coupon than a non-callable bond.
Callable bond

Advantages of Callable Bond


◆ Although a callable bond is a higher cost to the issuer and an
uncertainty to the investor comparing to a regular bond, it is actually
quite attractive to both issuers and investors.
◆ For issuers, callable bonds allow them to reduce interest costs at a
future date should rate decrease.
◆ For investors, callable bonds allow them to earn a higher interest rate of
return until the bonds are called off.
◆ If interest rates have declined since the issuer first issues the bond, the
issuer is like to call its current bond and reissues it at a lower coupon.
Callable Bond

Callable Bond Payoffs


◆ At the bond maturity T, the payoff of a callable bond is given by
𝐹+𝐶 𝑖𝑓 𝑛𝑜𝑡 𝑐𝑎𝑙𝑙𝑒𝑑
𝑉𝑐 𝑡 = ቊ
min(𝑃𝑐 , 𝐹 + 𝐶) 𝑖𝑓 𝑐𝑎𝑙𝑙𝑒𝑑
where F – the principal or face value; C – the coupon; 𝑃𝑐 – the call price; min (x, y) –
the minimum of x and y
◆ The payoff of the callable bond at any call date 𝑇𝑖 can be expressed as
𝑉𝑇 𝑖𝑓 𝑛𝑜𝑡 𝑐𝑎𝑙𝑙𝑒𝑑
𝑉𝑐 𝑇𝑖 = ቐ 𝑖
min 𝑃𝑐 , 𝑉 𝑇𝑖 𝑖𝑓 𝑐𝑎𝑙𝑙𝑒𝑑
where 𝑉 𝑇𝑖 – continuation value at 𝑇𝑖
Callable Bond

Model Selection Criteria


◆ Given the valuation complexity of callable bonds, there is no closed form
solution. Therefore, we need to select an interest rate term structure
model and a numerical solution to price them numerically.
◆ The selection of interest rate term structure models
◆ Popular interest rate term structure models:
Hull-White, Linear Gaussian Model (LGM), Quadratic Gaussian Model (QGM),
Heath Jarrow Morton (HJM), Libor Market Model (LMM).
◆ HJM and LMM are too complex.
◆ Hull-White is inaccurate for computing sensitivities.
◆ Therefore, we choose either LGM or QGM.
Callable Bond

Model Selection Criteria (Cont)


◆ The selection of numeric approaches
◆ After selecting a term structure model, we need to choose a numerical
approach to approximate the underlying stochastic process of the model.
◆ Commonly used numeric approaches are tree, partial differential equation
(PDE), lattice and Monte Carlo simulation.
◆ Tree and Monte Carlo are notorious for inaccuracy on sensitivity calculation.
◆ Therefore, we choose either PDE or lattice.
◆ Our decision is to use LGM plus lattice.
Callable Bond

LGM Model
◆ The dynamics
𝑑𝑋 𝑡 = 𝛼 𝑡 𝑑𝑊
where X is the single state variable and W is the Wiener process.
◆ The numeraire is given by
𝑁 𝑡, 𝑋 = 𝐻 𝑡 𝑋 + 0.5𝐻2 𝑡 𝜁 𝑡 /𝐷(𝑡)
◆ The zero coupon bond price is
𝐵 𝑡, 𝑋; 𝑇 = 𝐷 𝑇 𝑒𝑥𝑝 −𝐻 𝑡 𝑋 − 0.5𝐻2 𝑡 𝜁 𝑡
Callable Bond

LGM Assumption
◆ The LGM model is mathematically equivalent to the Hull-White model
but offers
◆ Significant improvement of stability and accuracy for calibration.
◆ Significant improvement of stability and accuracy for sensitivity calculation.
◆ The state variable is normally distributed under the appropriate
measure.
◆ The LGM model has only one stochastic driver (one-factor), thus
changes in rates are perfected correlated.
Callable Bond

LGM calibration
◆ Match today’s curve
At time t=0, X(0)=0 and H(0)=0. Thus Z(0,0;T)=D(T). In other words, the
LGM automatically fits today’s discount curve.

◆ Select a group of market swaptions.

◆ Solve parameters by minimizing the relative error between the market


swaption prices and the LGM model swaption prices.
Callable Bond

Valuation Implementation
◆ Calibrate the LGM model.
◆ Create the lattice based on the LGM: the grid range should cover at least
3 standard deviations.
◆ Calculate the payoff of the callable bond at each final note.
◆ Conduct backward induction process iteratively rolling back from final
dates until reaching the valuation date.
◆ Compare exercise values with intrinsic values at each exercise date.
◆ The value at the valuation date is the price of the callable bond.
Callabe Bond

A real world example


Bond specification Callable schedule
Buy Sell Buy Call Price Notification Date
Calendar NYC 100 1/26/2015
Coupon Type Fixed 100 7/25/2018
Currency USD
First Coupon Date 7/30/2013
Interest Accrual
1/30/2013
Date
Issue Date 1/30/2013
Last Coupon Date 1/30/2018
Maturity Date 7/30/2018
Settlement Lag 1
Face Value 100
Pay Receive Receive
Day Count dc30360
Payment Frequency 6
Coupon 0.015
Thanks!

You can find more details at


https://finpricing.com/lib/IrCurve.html

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