CHAPTER 13: THE VALUATION OF DEBT OPTIONS AND BONDS WITH

EMBEDDED OPTION FEATURESTHE BINOMIAL INTEREST RATE TREE

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. Given a current one-period spot rate of S0 = 10%, upward and downward

parameters of u = 1.1 and d = .9091, and probability of the spot rate increasing in
one period of q = .5:
a. Generate a two-period binomial tree of spot rates.
b. Using the binomial interest rate, determine the value of a two-period,
option-free 9% coupon bond with F = 100.
c. Using the binomial interest rate tree, determine the value of the 9% bond
assuming it is callable at a call price of CP = 99. Use the minimum
constraint approach.
d. Using the binomial interest rate tree, show at each node the call option
values of the callable bond (CP = 99). Given your call option values,
determine the values at each node of the callable bond as the difference
between the option-free values and the call option values. Do your callable
bond values match the ones you found in Question 1.c?
e. Using the binomial interest rate tree, determine the value of the bond
assuming it is putable in periods one and two at a put price of PP = 99. Use
the maximum constraint approach.
f. Using the binomial interest rate tree, show at each node the put option
values of the putable bond (PP = 99). Given your put option values,
determine the values at each node of the putable bond as the sum of the
option-free bond values and the put option values. Do your putable bond
values match the ones you found in Question 1.e?

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2. Given a current one-period spot rate of S0 = 5%, upward and downward parameter
of u = 1.1, d = 1/1.1, and probability of spot rate increasing in one period of q = .5:
a. Generate a two-period binomial tree of spot rates.

b. Using a binomial tree approach, calculate the value of a three-period, option-

free bond paying a 5% coupon per period and with a face value of 100.

c. Using the binomial tree, calculate the value of the bond given it is callable with
a call price = CP = 100.

d. Using the tree, calculate the value of the bond given it is putable in periods 1
and 2 with a put price = PP = 100.

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a. Binomial Tree of spot rates: u = 1.1, d = 1/1.1, and S0 = 5%:

b. The value of a three-period, option-free bond paying a 5% coupon per period and
with face value of 100 is 99.94772

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c. The value of three-period bond paying a 5% coupon per period and callable with
a call price = CP = 100 is 99.550869:

d. The value of three-period bond paying a 5% coupon per period and putable with
put price = PP = 100 is 100.39684:

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3. Given the following features of the XYZ convertible bond:
Coupon rate (annual) = 10%
Face value = F = $1,000
Maturity = 10 years
Callable at $1,100
YTM on a comparable, nonconvertible bond = 12%
Conversion ratio = 10 shares
Current stock price = S0 = $90

Calculate the following:

a. XYZ's conversion price
b. XYZ's conversion value
c. XYZ's straight debt value
d. Minimum price of the convertible
e. The arbitrage strategy if the price of the convertible were $880

a. Conversion Price (CP):

CP = F/CR
CP = $1,000/10 = $100
.
b. Conversion Value (CV):
CV = (CR)(S0)
CV = (10)($90) = $900

c. Straight Debt Value (SDV):

10 $100 $1000
SDV t
$887
t 1 (1.12) (1.12)10

d. Minimum Price of the Convertible (PCB):

MinPCB = Max[SDV,CV]
MinPCB = Max[$887,$900] = $900

e. Arbitrage Strategy: Buy convertible for $880, convert to 10 shares of XYZ stock,
then sell the stock at S0 = $90 per share for a profit of $20: Profit = (10)($90)
$880 = $20.

4. Given an ABC convertible bond with F = 1,000, maturity of three periods, CR = 10,
current stock price of $100, and u = 1.1, d = .95, and q = .5 on the stock:
a. Calculate the value of the bond using a binomial tree of stock prices. Assume
no call on the bond and a flat yield curve at 10% that is not expected to change.
b. Calculate the value of the bond using a binomial tree of stock prices. Assume
the bond is callable at CP = 1,200 and a flat yield curve at 10% that is not
expected to change.

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 a. The value of the bond using a binomial tree of stock prices and assuming no call
on the bond and a flat yield curve at 10% that is not expected to change is
1,073.20:

b. The value of the bond using a binomial tree of stock prices and assuming the bond
is callable at CP = 1,200 and a flat yield curve at 10% that is not expected to
change 1,071.47:

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Excel Problems: Excel programs called Binomial Callable Bond, Binomial Putable
Bond, and Binomial ValuationCallable and Putable can be downloaded from the
Web site that is associated with this book. These programs can be used to price callable
and putable bonds based on u and d inputs or mean and variance values. Problems 5 and
6 should be done using the programs.

5. Given a binomial interest rate tree with the following features: S0 = 6%, length of
the tree = .5 year, and upward and downward parameters for .5 years of u = 1.0488
and d = .9747 and q = .5, determine the values of the following bonds:
a. The value of an option-free bond with maturity of 10 years, annual coupon of C
= 6, semiannual payments, and F = 100.
b. The value of a callable bond with maturity of 10 years, annual coupon of C = 6,
semiannual payments, F = 100, and call price of 100.
c. The value of a putable bond with maturity of 10 years, annual coupon of C = 6,
semiannual payments, F = 100, and put price of 100.
d. The value of an option-free bond with maturity of 20 years, annual coupon of C
= 6, semiannual payments, and F = 100.
e. The value of a callable bond with maturity of 20 years, annual coupon of C = 6,
semiannual payments, F = 100, and call price of 100.
f. The value of a putable bond with maturity of 20 years, annual coupon of C = 6,
semiannual payments, F = 100, and put price of 100.

Excel problems:
a. 95.50
b. 95.36
c. 100.31
d. 87.84
e. 87.76
f. 100.35

6. Given the following:

Current spot = 0.08
Annualized mean for the spot rates logarithmic return of .022
Annualized variance for the spot rates logarithmic return of .0054
Binomial interest rate tree with monthly steps

Determine the values of the following:

a. 5-year, 8% option-free bond, with F = 100.
b. 5-year, 8% callable bond (F = 100) with call price = 100.
c. 5-year, 8% putable bond (F = 100) with put price = 100.

a. Price of 5-year, 8% option-free bond = 98.15

b. Price of 5-year, 8% callable bond with call price of 100 = 97.75
c. Price of 5-year, 8% putable bond with put price of 100 = 100.47

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7. Explain how subdividing the number of periods to expiration makes the binomial
interest rate tree more realistic.

In a multiple-period model, one divides the time to expiration into a number of

subperiods of smaller length. As the length of the subperiod becomes smaller, the
assumption that the spot rate follows a binomial process becomes more plausible, and, as
the number of subperiods increase, the number of possible rates at expiration is greater,
again adding more realism to the model.

8. Explain the methodology used for deriving the formulas for u and d.

The formulas for estimating u and d are found by solving for the u and d values that make
the expected value and the variance of the binomial distribution of the logarithmic return
of spot rates equal to their respective estimated parameter values under the assumption
that q = .5 (or equivalently that the distribution is normal). If we let and e and Ve be the
estimated mean and variance of the logarithmic return of spot rates for a period equal in
length to n periods, then the u and d formula are found by solving for the u and d that
simultaneously satisfy the following equations:

nE(g 1 ) n[q ln u (1 q ) ln d ] e
nV(g 1 ) nq(1 q )[ln(u / d )] 2 Ve .

If q = .5, then the formula values for u and d that satisfy the two equations are

Ve / n e / n
u e
Ve / n e / n
d e .
9. Suppose a spot rate has the following prices over the past 13 quarters:

Quarter Annualized Spot Rate (%)

y 1.1 5.5
y 1.2 5.0
y 1.3 4.7
y 1.4 4.4
y 2.1 4.7
y 2.2 5.0
y 2.3 5.4
y 2.4 5.0
y 3.1 4.7
y 3.2 4.4
y 3.3 4.7
y 3.4 5.0
y 4.1 5.5
a. Calculate the spot rates average logarithmic return and variance.

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 b. What is the rate's annualized mean and variance?
c. Calculate the spot rate's up and down parameters for periods with the
following lengths:
(1) One quarter (h = length in years = 1/4)
(2) One month (h = 1/12)
(3) One week (h = 1/52)
(4) One day (h = 1/360)

a. The average logarithmic return is zero and the variance is .0057027.

Quarter Spot Rates (%), St St/St-1 gt=ln(St/St-1) [gt- eq]2

y1.1 5.5 -- -- -
y1.2 5.0 5.0/5.5 .095310 .0090840
y1.3 4.7 4.7/5.0 .061875 .0038286
y1.4 4.4 4.4/4.7 .065958 .0043505
y2.1 4.7 4.7/4.4 .065958 .0043505
y2.2 5.0 5.0/4.7 .061875 .0038286
y2.3 5.4 5.4/5.0 .076961 .0059230
y2.4 5.0 5.0/5.4 .076961 .0059230
y3.1 4.7 4.7/5.0 .061875 .0038286
y3.2 4.4 4.4/4.7 .065958 .0043505
y3.3 4.7 4.7/4.4 .065958 .0043505
y3.4 5.0 5.0/4.7 .061875 .0038285
y4.1 5.5 5.5/5.0 .095310 .0090840
0 .06273
q
Ve = .06273/11
eq = 0 Veq = .0057027

b. The annualized mean and variance are:

eA = 4 eq = 4(0) = 0
VAe = 4 Veq = 4(.0057027) = .0228108.
c.

Length of
u d
Period
Quarter: h = 1/4 1.078441 .927265
Month: h = 1/12 1.044564 .957337
Week: h = 1/52 1.021165 .979273
Day: h = 1/360 1.007992 .992071

u e h (.0228108 )
d e h (.0228108 )

10. Explain the methodology for estimating a binomial tree using the calibration
model. Comment on the arbitrage-free features of this approach.

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The calibration model generates a binomial tree by first finding spot rates that satisfy a
variability condition between the upper and lower rates. From the u and d approach, the
variability condition is

2 hVeA
Su Sd e

Given the variability relation, the model then solves for the lower spot rate that satisfies a
price condition in which the bond value obtained from the tree is consistent with the
equilibrium bond price given the current yield curve. This is done by first finding the S d
value that will yield a one-period binomial tree that generates a price for a two-period
bond that is equal to the equilibrium price on a two-period bond. Given the one-period
tree, the Sdd value is next found by solving for the S dd that along with the variability
condition and the Su and Sd values will yield a two-period binomial tree that generates a
price for a three-period bond that is equal to the equilibrium price on a three-period bond.
This process is then repeated.

Features: Since the binomial tree is calibrated to the current spot rate, one of the features
of the calibrated tree is that it yields values on option-free bonds that are equal to the
bonds equilibrium price. Since a bonds equilibrium price is an arbitrage-free price, the
calibration model satisfies an arbitrage-free condition in pricing option-free bonds. The
calibration model also has the feature of pricing embedded options equal to their
arbitrage-free prices. That is, in pricing bonds with embedded options, the embedded
option values at each node in a binomial tree are also equal to the values of their
replicating portfolios. Because of this feature and the feature of pricing option-free bonds
equal to their equilibrium prices, the calibration model is referred to as an arbitrage-free
model.

11. Given a variability of = hVeA = .10 and current one-, two-, and three-period
spot rates of y1 = .07, y2 = .0804, and y3 = .0904952:
a. Generate a two-period binomial interest rate tree using the calibration model.
(Hint: try Sd = .08148 from Problem 10 and Sdd = .0906)
b. Using the calibrated tree, determine the equilibrium price of a three-period,
10.5% option-free bond (F = 100).
c. Does the binomial tree price the 10.5% option-free bond equal to the bonds
equilibrium price?
d. Using the calibrated tree, calculate the value of a three-period, 10.5% bond (F
= 100) callable at CP = 101 in periods 1 and 2.
e. Based on the option-free and callable bond values you determined in 10.b and
10.d, estimate the option-adjusted spread.

a. Given = .10, the variability condition governing the upper and lower rates is

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 2 hVe
S u Sd e
Su Sd e 2 Sd e 2 (.10)

Given the variability condition, the tree is generated by first solving for the S d value
that makes the value of a two-year zero discount bond obtained from the tree equal to
its current equilibrium price of .857 (= 1/(1.0804)2):

1 .5[1 /(1 Sd e 2(.10) )] .5[1 /(1 Sd )]

.
(1.0804) 2 1.07

Solving the above equation for Sd, yields a rate of 8.148%. Thus, at S d = 8.148%, Su
is equal to 9.952% and the binomial tree yields a bond price of .857 for a two-period
zero coupon bond with F = 1:

Given the variability condition, Sd = 8.148%, and Su = 9.952%, the spot rates for period
2 are next found by solving for the S dd value that makes the value of a three-year zero
discount bond obtained from the tree equal to its current equilibrium price of .77113 (=
1/(1.0904952)3). The Sdd value that satisfies the above equation can be found iteratively
(or take the hint); in this case, S dd is 9.06%. Given Sdd = 9.06%, by the variability
condition Sud is 11.066% and Suu is 13.516%. This tree yields a price for a three-period

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zero-coupon bond with a face value of $1 of .77113the same value as the equilibrium
price.

The two-period binomial tree is

b. Using the tree, the price of a three-period, 10.5% coupon bond is 104.02:

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c. The equilibrium price on a three-period, 10.5% coupon bond is 104.02the same as
the price obtained using the calibrated binomial tree:

10.50 10.50 110.50

B0M 2
104.02
1.07 (1.0804) (1.0904952) 3

d. Using the tree, the price of a three-period, 10.5% coupon bond callable at CP =101 is
103.30:

S uu . 0 906 e 4 (. 10 ) . 13516 B uuu 110 . 50

110 . 50
B uu 97 . 343106
( 1 . 13516 )
CP 101
S u . 08148 e 2 (. 10 ) . 09952 B Cuu Min [ B uu , CP ] 97 . 34106
. 5 ( 97 . 343106 10 . 50 ) . 5 ( 99 . 4904 10 . 50 )
Bu
1 . 09952 B uud 110 . 50
99 . 058456
CP 101
B Cu Min [ B u , CP ] 99 . 058456
S ud . 0 906 e 2 (. 10 ) . 11066
S 0 . 07 110 . 50
B ud 99 . 4904
. 5 ( 99 . 058456 10 . 50 ) . 5 ( 101 10 . 50 ) ( 1 . 11066 )
B0
1 . 07 CP 101
103 . 30
B Cud Min [ B ud , CP ] 99 . 4904
S d . 08148
. 5 ( 99 . 4904 10 . 50 ) . 5 ( 101 10 . 50 )
Bd B udd 110 . 50
1 . 08148
102 . 4015
CP 101
B Cd Min [ B d , CP ] 101 S dd . 0 906
110 . 50
B dd 101 . 3204
1 . 0906
CP 101
B Cdd Min [ B dd , CP ] 101
B uuu 110 . 50

e. Option-Adjusted Spread .2772%:

10.50 10.50 110 .50

Option Free Bond : 104.02
1 YTM (1 YTM ) 2
(1 YTM ) 3
YTM NC 8.9143%
10.50 10.50 110 .50
Callable Bond : 103.30
1 YTM (1 YTM ) 2 (1 YTM ) 3
YTM C 9.1915%
Option Spread YTM c YTM NC 9.1915% 8.9143% .2772%

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12. Explain how a spread is estimated using the option-adjusted spread analysis.

OAS analysis solves for the option spread, k, that makes the average of the present values
of the bonds cash flows from all of the possible interest rate paths equal to the bonds
market price. The first step in this approach is to specify the cash flows and spot rates for
each path defined by a binomial interest rate tree. Given the cash flows and spot rates for
each path, the next step is to determine the appropriate spot rates to discount the cash
flows. These rates can be found using the geometric mean and the one-period spot rates
from the tree. Given a discount rate equal to the spot rate plus the spread, k, the final step
is to solve for the k that makes the average present values of the paths equal to the
callable bonds market price, BM0.

13. Explain the methodology used to estimate a bonds duration and convexity with the
calibration model.

The duration and convexity of bonds with embedded option features can be estimated
using a calibrated binomial tree and the effective duration and convexity measures:
B B
Effective Duration
2(B 0 )(y)
B B 2B 0
Effective Convexity ,
(B 0 )(y) 2

where: B = price associated with a small decrease in rates

B+ = price associated with small increase in rates

The binomial tree calibrated to the yield curve can be used to estimate B 0, B and B+.
First, the current yield curve and calibrated tree can be used to determine B 0. Next, B
can be estimated by allowing for a small equal decrease in each of the yield curve rates
(e.g. 10 basis points) and then using the tree calibrated to the new rates to find the price.
Finally, B+ can be estimated in a similar way by allowing for a small equal increase in the
yield curves rates and then estimating the bond price using the tree calibrated to these
higher rates.

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