Abstract
This paper examines the behavior of the interest rate risk management measures for bonds with embedded options and studies factors it depends on. The contingent option exercise implies that both the pricing and the risk management of bonds requires modelling future interest rates. We use the Ho and Lee (HL) and Black, Derman, and Toy (BDT) consistent interest rate models. In addition, specific interest rate measures that consider the contingent cash-flow structure of these coupon-bearing bonds must be computed. In our empirical analysis, we obtained evidence that effective duration and effective convexity depend primarily on the level of the forward interest rate and volatility. In addition, the higher the interest rate change and the lower the volatility, the greater the differences in pricing of these bonds when using the HL or BDT models.
Highlights
The aim of this paper is to analyze and interpret interest rate risk management measures for option-embedded bonds under different specifications of interest rate dynamics
We assumed that the bond’s yield-to-maturity (YTM) was the spot interest rate provided by the yield curve for the term to maturity or to the exercise date on that date plus the average option-adjusted spread (OAS) of the issue over its life (55 bp for the Banco de Crédito Local (BCL) and 126 bp for the
We obtained evidence that the differences between the measures proposed for option-embedded bonds, effective duration (ED) and Effective convexity (EC), and the traditional measures applied for option-free bonds were generated and depended on the probability of exercising the call or put options at each moment
Summary
The aim of this paper is to analyze and interpret interest rate risk management measures for option-embedded bonds under different specifications of interest rate dynamics. We studied the factors, on which they depend, based on the assumption that the choice of the consistent interest rate model used to price these securities can have a significant impact on the calculation of those measures. The pricing of these bonds requires modelling of future interest rates from the actual term structure of interest rates and the actual term structure of volatility. We estimated different measures of interest risk management and examine the main factors that determine their behavior, such as the interest rate volatility, the shape of the yield curve, and the changes in the yield curve
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