Valuing Bonds With Embedded Options

Question 0

Which three benchmark int rates used to calc spreads

Answer 0

US treasury securities
Sector of bond market; cr rating> issue
A specific issuer

Question 1

What are steps for valuing option free bonds with backward induction

Answer 1

1. Start at maturity, calculate up node; use forward rate up&midtick
2. Calculate down node; use forward rate mid&downtick
3. Find PV by taking value at each node, add coupon, divide by discount and average

Question 2

What is the major difference when calculating a callable bond

Answer 2

At each node, you must assess whether the price at which issuer calls the bond is less than calculated value; lower value should be used in int rate tree calcs

Question 3

How to calc a callable bond

Answer 3

1. Start at maturity; take avg of up and mid tick, discount at uptick
2. Take and of down and mid tick, discount at downtick
3. If either value > call price, use call price
4. Discount using values accounting for call option

Question 4

What is value of call

Answer 4

Vcall = Vnoncallable - Vcallable

Question 5

What is value of put

Answer 5

Vput = Vputable - Vnonputable

Question 6

What is option adjusted spread

Answer 6

Constant spread added to arbitrage free int rate tree which makes calculated bond price equal market price

Question 7

What is nominal spread

Answer 7

Difference in yield due to credit, liquidity and option risks

Question 8

Why is option adjusted spread useful

Answer 8

If we compare OAS with required adjustment for credit and liquidity risk and it’s bigger, bond is underpriced

Question 9

What are convertible bonds

Answer 9

Bonds that can be converted to specific num of shares at holders option

Question 10

How to calc conversion value for convertible bond

Answer 10

Conversion value = market price * conversion ratio

Question 11

What is straight value

Answer 11

PV of CFs of comparable option free issue; discount at required rate of return

Question 12

What is minimum value of convertible bond

Answer 12

Greater of conversion and straight value

Question 13

How to calc market conversion price

Answer 13

Market conversion price = market price of convertible / conversion ratio

Question 14

How to calc value of callable convertible bond

Answer 14

Callable convertible bond = straight value of bond + value of the call option on stock - value of call option on bond

Question 15

An increase in _______ will increase value of the call on a stock and increase value of callable convertible bond

Answer 15

Stock price volatility

Question 16

An increase in _______ will increase value of the call on a bond and increase value of callable convertible bond

Answer 16

Interest rate volatility

Question 17

Key advantage of buying convertible bond

Answer 17

Limit downside risk; at cost of reduced upside potential (conversion premium)

Question 18

Premium payback period

Answer 18

Market conversion premium per share / (per share bond coupon - dividend per share )

Question 19

Market conversion premium per share

Answer 19

Market conversion price per share - market price per share