BondPricing

Recallthatabondwithanembeddedcall
optionshouldbepricedsuchthat
Priceofa
callable
bond

Priceofa
noncallable
bond

Priceofthe
calloption

NoncallableBondPricing
Traditionalyieldspreadmethod
BasedonYTM
Ignoresdifferencesincashflowcharacteristics

Staticspreadanalysis
Basedontermstructure
Allowsfordifferencesincashflowcharacteristics

StaticSpreadAnalysis
ThebenchmarkistheTreasurytermstructure
Term Structure
9.00%
8.50%
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
1

10

11

Term to Maturity

12

13

14

15

StaticSpreadAnalysis
Thetermstructureimpliesasetofzeroprices
thatcanbeusedtopriceanycashflow
1
B(0,t) =
t
1+R(0,t)
(
)

StaticSpreadAnalysis
ThebenchmarkistheTreasurytermstructure.

Heresan
example

Term
t
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Spot Yield
R(0,t)
5.36%
5.68%
5.97%
6.24%
6.48%
6.70%
6.89%
7.08%
7.24%
7.39%
7.53%
7.66%
7.78%
7.89%
7.98%

Zero Price
B(0,t)
$ 0.94916
$ 0.89541
$ 0.84030
$ 0.78508
$ 0.73068
$ 0.67784
$ 0.62706
$ 0.57870
$ 0.53298
$ 0.49001
$ 0.44983
$ 0.41241
$ 0.37769
$ 0.34557
$ 0.31592

StaticSpreadAnalysis
Weusethetermstructuretopricethecashflow
ofabondwewishtoprice.
Forexample,
supposewe
wanttoprice
a15year
12%coupon
corporate
bond.

Term
t
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Spot Yield
R(0,t)
5.36%
5.68%
5.97%
6.24%
6.48%
6.70%
6.89%
7.08%
7.24%
7.39%
7.53%
7.66%
7.78%
7.89%
7.98%

Zero Price
B(0,t)
$ 0.94916
$ 0.89541
$ 0.84030
$ 0.78508
$ 0.73068
$ 0.67784
$ 0.62706
$ 0.57870
$ 0.53298
$ 0.49001
$ 0.44983
$ 0.41241
$ 0.37769
$ 0.34557
$ 0.31592

Cash
Flow

$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$ 112.00
Theoretical price

Present
Value
$ 11.38989
$ 10.74491
$ 10.08364
$
9.42090
$
8.76818
$
8.13407
$
7.52475
$
6.94444
$
6.39578
$
5.88013
$
5.39795
$
4.94894
$
4.53228
$
4.14678
$ 35.38272
$ 139.69536

StaticSpreadAnalysis
Thedifferencebetweenthebondsmarketprice
anditstheoreticalriskfreepricereflectsthe
yieldpremiuminvestorsdemandforbearing
risk.
Forexample,the12%15yearcorporatewas
pricedat8615/16recently.
Wecalculatedatheoreticalpriceof139.695for
thisbond,whichimpliesapricedifferentialof
$52.758per$100offacevalue.

StaticSpreadAnalysis
Thestaticspreadistheyieldpickup(over
andabovethetermstructure)neededtoequate
thepresentvalueofabondscashflowwithits
price.
Thatis,insteadofusingthetermstructureto
valueabondscashflow,weuse
1
B (0,t) =
t
(1+R(0,t) +s)

StaticSpreadAnalysis
Forexample:
Inthiscase,the
bondispricedat
a682bpstatic
spread(overthe
Treasuryterm
structure)

Bond Coupon 12.00%

Bond Price 86 15/16
Static Spread
6.82%
Term
t
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Spot Yield
R(0,t)
5.36%
5.68%
5.97%
6.24%
6.48%
6.70%
6.89%
7.08%
7.24%
7.39%
7.53%
7.66%
7.78%
7.89%
7.98%

Zero Price
B(0,t)
$ 0.89147
$ 0.79017
$ 0.69696
$ 0.61216
$ 0.53576
$ 0.46745
$ 0.40678
$ 0.35319
$ 0.30607
$ 0.26480
$ 0.22877
$ 0.19740
$ 0.17016
$ 0.14655
$ 0.12612

Cash
Flow

$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$
12.00
$ 112.00
Theoretical price
Price spread

Present
Value
$ 10.69768
$
9.48210
$
8.36349
$
7.34595
$
6.42909
$
5.60941
$
4.88139
$
4.23831
$
3.67286
$
3.17761
$
2.74525
$
2.36885
$
2.04194
$
1.75858
$ 14.12499
$ 86.93751
$
0.00001

StaticSpreadAnalysis
CuttoEXCELspreadsheetexample

OptionValue
Staticspreadsarenotusefulforpricingcallable
bondsbecausetheydonotaccountforinterest
ratevolatility,whichaffectsthevalueofthe
embeddedoption.
Commonpracticeinpricingcallablebondsisto
computetheOptionAdjustedSpread,or
OAS.
Interestratevolatilityismodeledasabinomial
process.

BinomialOptionPricing
Thebinomialmodelisbasedonthesimplifying
ideathatassetprices(orinterestrates)can
moveupbyu%ordownbyd%fromperiodto
period.
Now

Now+1
P*(1+u)

P*(1+d)

Forexample
Considerthestockpricedynamics:
t = now

$40

t = now + 1
month
$40x(1+.25) =
$50

up
state

$40x(1-.125)
= $35

down
state

Forexample
Supposeacalloptiononthisstockhasastrike
priceof$45
t=
0

t=
1

Stock
Price=$50;

Stock
Price=$40;

Call Value=$5

Call Value=$c

Stock
Price=$35;
Call Value=$0

Areplicatingportfolio
Consideraportfoliocontainingsharesofthe
stockand$Binvestedinriskfreebonds.
Thepresentvalue(price)ofthisportfoliois
S +B =$40S+B

Valueoftheportfolio
t=
0

t=
1
$50 +
(1+r/12)B

up
state

$35+
(1+r/12)B

down state

$40 + B

Areplicatingportfolio
Thisportfoliowillreplicatetheoptionifwecan
findaandaBsuchthat
Up state
$50 + (1+r/12) B
= $5 and
Down
$35 + (1+r/12) B
state
= $0
=
Portfolio payof
Option payof

Thereplicatingportfolio
Solution:
=1/3
B=35/(3(1+r/12)).

Eg,ifr=6%,thentheportfoliocontains
1/3shareofstock(currentvalue$40/3=$13.33)
partiallyfinancedbyborrowing$35/(3x1.005)=
$11.61

Thereplicatingportfolio
Payoffsatmaturity

Stock Price
1/3 Share
Bond Repayment
Net portfolio

$
$
$
$

up state
50.00
16.67
11.67
5.00

down state
$
35.00
$
11.67
$
11.67
$
-

Thereplicatingportfolio
Sincethethereplicatingportfoliohasthesame
payoffastheoptioninallstates,thetwomust
alsohavethesameprice.
Thepresentvalue(price)ofthereplicating
portfoliois$13.33$11.61=$1.72.
Therefore,c=$1.72

Ageneral(1period)formula
Cu Cd
=
Su Sd

Anotherlookatit
Recallthestockpricedynamics
$50
$40
$35

OptionValue
Whichimpliestheoptionvalue(fora$45strike
price):
$5
Call
Price

$0

CoveredCalls
SupposeyouwriteHcoveredcalloptions:
$50 - (H x $5)
$40 - (H
x Call
Price)

$35 - (H x $0)

Yourcost

Yourvalueatt+1

WritingHCoveredCalls
$50 - (H x $5)
$40 - (H
x Call
Price)

The investment is risk free if

these two quantities are equal

$35 - (H x $0)

WritingHCoveredCalls
$50 - (H x $5)
$40 - (H
x Call
Price)

These quantities are equal (to

$35) when H = 3

$35 - (H x $0)

RiskFreeInvesting
Sinceaninvestmentof$40(3xCallPrice)
willproduce$35forcertain,itmustequalthe
presentvalueof$35discountedattheriskfree
interestrate

$35
$35
$403Call
=
$403Call Price
Price
=
rr
1+
1+
12
12

PriceofaCall
Thiswillbetrueifandonlyifthecallispricedat

$35
$35
$40+
$40+ rr
1+ ))
((1+
12
12
Call
=
Call Price
Price
=
33

ForExample
Iftheriskfreeinterestrateis6%perannum,then

$35
$35
$40
$40
1.005
1.005
Call
=$1.72
Call Price
Price=
=
=$1.72
33

TheOnePeriodFormula
TheoneperiodpricingformulaforaEuropean
callpayingnodividendsinthestandard
binomialmodelis

TheOnePeriodFormula

Example
TelMex
TelMex Jul
Jul 45
45

3
5
143
143 CB
CB 223//1616 --5//1616 47
47

Binomial
BinomialModel
ModelCall
CallOption
Option
Price
PriceCalculator
Calculator
Stock
StockPrice
Price
Exercise
ExercisePrice
Price
Years
Yearsto
toMaturity
Maturity
Risk-free
Risk-freeRate
Rate(per
(perannum)
annum)
Ru
Ru
Rd
Rd
pp
Stock
StockValue
Valuein
inUp
UpState
State
Call
CallValue
Valuein
inUp
UpState
State
Stock
StockValue
Valuein
inDown
DownState
State
Call
CallValue
Valuein
inDown
DownState
State
Call
CallValue
Value

2,703
2,703

$47.00
$47.00
$45.00
$45.00
0.08
0.08
5.00%
5.00%
6.50%
6.50%
-4.50%
-4.50%
44.70%
44.70%
$50.06
$50.06
$5.06
$5.06
$44.89
$44.89
$0.00
$0.00
$2.25
$2.25

TwoPeriods
Theassumptionthattheunderlierpricechanges
onlyonceduringthelifeoftheoptionis
obviouslyunrealistic
Supposetwopricechangesarepossibleduring
thelifeoftheoption
Ateachchangepoint,thestockmaygoupbyRu
%ordownbyRd%

TwoPeriodStockPrice
Dynamics
Forexample,supposethatineachoftwo
periods,astockspricemayriseby3.25%or
fallby2.5%
Thestockiscurrentlytradingat$47
Attheendoftwoperiodsitmaybeworthas
muchas$50.10oraslittleas$44.68

TwoPeriodStockPrice
Dynamics
$50.10
$48.53
$47

$47.31
$45.83
$44.68

TerminalCallValues
At expiration, a call with a strike
price of $45 will be worth:

Cuu =$5.10

$Cu
$C0

Cud =$2.31
$Cd
Cdd =$0

TwoPeriods
ThetwoperiodBinomialmodelformulafora
Europeancallis

Example
TelMex
TelMex Jul
Jul 45
45

3
5
143
143 CB
CB 223//1616 --5//1616 47
47

Two
TwoPeriod
PeriodBinomial
BinomialModel
Model
Call
Option
Price
Calculator
Call Option Price Calculator
Stock
$47.00
StockPrice
Price
$47.00
Exercise
$45.00
ExercisePrice
Price
$45.00
Years
0.08
Yearsto
toMaturity
Maturity
0.08
Risk-free
5.00%
Risk-freeRate
Rate(per
(perannum)
annum)
5.00%
Ru
3.25%
Ru
3.25%
Rd
-2.50%
Rd
-2.50%
pp
47.10%
47.10%
Stock
Value
in
Up
Up
State
$
50.10
Stock Value in Up Up State
$ 50.10
Call
Value
in
Up
Up
State
$
Call Value in Up Up State
$ 5.10
5.10
Stock
$$47.31
StockValue
Valuein
inDown
DownUp
UpState
State
47.31
Call
$$ 2.31
CallValue
Valuein
inDown
DownUp
UpState
State
2.31
Stock
StockValue
Valuein
inDown
DownDown
DownState
State $$44.68
44.68
Call
Value
in
Down
Down
State
$
Call Value in Down Down State
$ -Call
$$ 2.28
CallValue
Value
2.28

2,703
2,703

BinomialTrees
CuttoEXCELexample