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Analysis of Bonds with Embedded Options. Zvi Wiener Based on Chapter 14 in Fabozzi Bond Markets, Analysis and Strategies. Static Spread. Yield difference is a bad measure of profitability since it does not account for term structure of IR and difference in cashflows.
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Analysis of Bonds with Embedded Options Zvi Wiener Based on Chapter 14 in Fabozzi Bond Markets, Analysis and Strategies http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Static Spread • Yield difference is a bad measure of profitability since it does not account for term structure of IR and difference in cashflows. • Static spread: create an artificial cashflow using zero-coupon IR, then calculate the difference in yields. • See example in Exhibits 14-1, 14-2. Fabozzi Ch 14
Negative convexity area Callable Bond price non-callable callable yield Callable bond = noncallable – call option price Fabozzi Ch 14
Option-Free Bond • Price = present value of the cash flow discounted at spot rates. Years YTM Market Value 1 3.5% 100 2 4.0% 100 3 4.5% 100 Years Spot rate Forward (1y) 1 3.500% 3.500% 2 4.010% 4.523% 3 4.541% 5.580% Fabozzi Ch 14
Option-Free Bond • 5.25% coupon bond with 3 years to maturity: Fabozzi Ch 14
r3,HHH r2,HH r1,H r3,HHL r2,HL r1,L r3,HLL r2,LL r3,LLL r0 Fabozzi Ch 14
r3e6 r2e4 r1e2 r3e4 r2e2 r0 r1 r3e2 r2 r3 Fabozzi Ch 14
Note that Fabozzi Ch 14
Option-Adjusted Spread OAS • OAS is the spread over the spot rate curve that is due to the embedded options. • Modified duration often assumes fixed cashflow. • A better measure is option-adjusted or effective duration. Fabozzi Ch 14
Effective Duration • P- -price if yield is decreased by y • P+ -price if yield is increased by y • P0 – initial price of the bond Fabozzi Ch 14
Effective Convexity Fabozzi Ch 14
Home AssignmentChapter 14 • Ch. 14: Questions 2, 7, 13, 20, 22 Fabozzi Ch 14