Abstract
In this paper, a valuation framework is developed for the variable rate demand obligation (VRDO). The VRDO is a class of floating rate note whose coupon rate changes on a regular basis and is “puttable” by the bondholder, given a notice of one week to the issuer. We model the coupon rate as a geometric Brownian motion process and assume that the incidence of puts is Poisson distributed, across time. Put events are assumed to be brought about by factors such as a change in the liquidity and consumption preferences of investors or a change in a Municipal issuer’s creditworthiness. This paper is unique because as of July 2019 there exists no attempt at valuing VRDOs in the research literature.
Highlights
IntroductionThe purpose of this paper is to develop a valuation framework for a variable rate demand obligation (VRDO)
This paper is unique because as of July 2019 there exists no attempt at valuing variable rate demand obligation (VRDO) in the research literature
The purpose of this paper is to develop a valuation framework for a variable rate demand obligation (VRDO)
Summary
The purpose of this paper is to develop a valuation framework for a variable rate demand obligation (VRDO). The concepts underlying the VRDO are simple They are floating rate obligations that have a nominal long-term maturity but have a coupon rate that is reset either daily or less frequently, depending upon the terms and conditions specified in the bond agreement (Dawson [1] [1993]). A stochastic model is developed in which the coupon rate follows a geometric Brownian motion process and the arrival time of the put by the investor conforms to negative exponential distribution. The latter is equivalent to the probability of an arrival, within a given time interval, being Poisson distributed. Certain market conditions may cause many investors to put back their bonds with the issuer simultaneously
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