AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

1Whatarecallablebonds?
Whenyoutakeoutafixedratemortgagetobuyahouse,youusuallyhavetheoptionofprepayingthe
mortgage.Thecommontermtouseistorefinance.Andpeoplewouldrefinancetheirmortgages
whenitischeaptodosowheninterestratesarelow.
Callablebondsareverysimilarexceptthatnowcompaniesaretheborrowers.Theyissuecallablebonds
toborrowmoneyforwhateverreason(notnecessarilytobuyhouses).Beingcallable,suchbondsgive
themtherighttocallhomethebondsprepaytheirborrowingswhentheyseefit,whichusually
meanswheninterestratesarelow.
Topayoffthebonds,theissuersusuallyhavetopaytheholderthefacevalueofthebonds.Formany
callablebonds,however,theissuerswillneedtopaysomepremiumontopofthefacevalue.This
premiumactsassomecompensationforthelenderswhouponbeingprepaid,havetofindnew
borrowersatgenerallylowerinterestrates.Thepricethattheissuershavetopayisthecallprice.
Sincecallablebondsareattractivetoborrowers,theyaredislikedbylenders.Althoughlendersget
compensatedthroughhighercouponrateswithcallablebonds,totonedowncallriskswithcallable
bonds,manyissuersintroduceacallprotectionperiodduringwhichacallablebondcannotbecalled.A
typicalcallablebondstructurewilllooklike10NC5:whichmeansthebondhas10yearstillmaturity
andonlycallableafteryear5.
2Whyarecallablebonds?
Itisobviousthatcallablebondsgiveborrowerstheoptiontorefinancewheninterestratesarelow.In
otherwords,itisonewaycompanieshedgeagainstpossibledecreasesinfutureinterestrates.Forthis
reason,callablebondsareverypopularbefore1990.Infact,before1970almostallcorporatebonds
wereissuedwithcallfeatures.Between1970and1990,about80%offixedratecorporatebondswere
callable.Duetothedevelopmentoftheinterestratederivativesmarketsinthelateeightiesandearly
nineties,therehasbeenabigdropincallablebondsissuancenowaccountingforonly30%ofthe
total.Thisisunderstandablesincewithderivatives,itbecomesevereasiertohedgeagainstinterestrate
risks.Withcallablebonds,providersofcapital(lenders)alsoactasinsuranceproviders.Thismaynotbe
necessarilyoptimalthesamewayapersonmaynotbegoodatbothtennisandfinance.Duetocost
savingsfromspecialization,companiesmayfinditmorecosteffectivetoborrowbyissuingstraight
bondsandbuyinsuranceagainstinterestraterisksfromspecializedinsuranceproviders.
However,anotherreasonwhyfirmsmaystillfindcallablebondsdesirableisthatbyissuingcallable
bondstheycansendastrongpositivesignaltothemarketsaboutthequalityoftheirbusiness.The
reasoninggoesasfollows:Ifafirmisconfidentabouttheirbusinessandbelievesthattheircreditquality
willimproveinthefuture(whichwilllowertheirborrowingcosts),itmakessenseforthemtoissuea
callablebond.Assoonasthemarketrealizestheirbettervalues,theycansimplycalltheoldexpensive
bondandreplaceitwithabondwhichpayslowercoupons.Ontheotherhand,ifafirmknowsthatthey
arenotdoingparticularlywellandtheircreditqualityisverylikelytodeteriorate,itmakessensefor
themtoissueanoncallablebondtolockinaborrowingrate.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

3Yieldstocallandyieldstoworst
Tradersliketothinkintermsofyieldtomaturitysimplybecauseitisseeminglyeasiertounderstand.A
bondistradingatayieldof5%seemsmorestraightforwardascomparedtoabondtradingat95.24%
offacevalue.Forthisreason,marketshavecomeupwithyieldsmeasuresforcallablebondsaswell.We
willtalkaboutthesemeasuresinthissection.
Strictlyspeaking,yieldtomaturityisoutofquestionforcallablebonds.Thesimplereasonisthatcallable
bondsdonthavefixedmaturities.Takeforanexample,the10NC5bond(10yearstatedmaturity,only
callableafter5years).Iftheissuer,forsomereasons,decidestocallthebondatendofyear
5/beginningofyear6,thematurityofthebondis5years.However,itisalsopossiblethattheissuer
mayletthebondliveuntilitsusualmaturityof10years.Withoutafixedmaturity,wearenotcertain
aboutthecashflowseitherandassuchayieldtomaturitycannotbecomputed.
However,tradersareinlovewithyieldsmeasuresandthustheyhavecomeupwithatleast2waysof
computingyieldsforcallablebonds.

First,theyassumethatthebond,thoughcallable,willnotbecalledatallduringitsentirelife.In
our10NC5bondexample,thismeansthebondsmaturitywillbe10years.Yieldcomputed
withthisassumptionisstillcalledyieldtomaturity.
Second,theyassumethatthebondwillbecalledwithcertainty.Inour10NC5bondexample,
thismeansthatthebondwillmatureatyear5.Yieldcomputingwiththisassumptionisyieldto
call.Manycallablebondshoweverhavemultiplecalldates.Forexample,our10NC5bondcan
becalledanytimeafteryear5untilyear10.Inthiscase,weneedtobeveryspecificaboutthe
callassumption.Ifweassumethatthebondwillbecalledattheendofyear5withcertainty,
strictlyspeaking,theresultingyieldwillbecalledyieldtofirstcall.

Toavoidpossibleconfusion,letmegiveasimpleexampleforustoquicklygrasptheconcept.Tomakeit
simple,letsworkwitha2yearbondthatcanonlybecalledatendofyear1foracallpriceof$100.This
bond,currentlysellingfor$99,hasafacevalueof$100andispayingasemiannualcouponrateof8%
p.a.
Yieldtomaturity
Tocomputeyieldtomaturityofthiscallablebond,wewillmaketheassumptionthatthebondwillbe
heldtomaturityregardless.Therefore,thecashflowsfromthebondwillsimplybe:

Attime0.5:
Attime1.0:
Attime1.5:
Attime2.0:

$4
$4
$4
$104

Theyieldtomaturityofthebondwillthenbeysuchthat:

AdvancedFixedIncome

CallableBonds

99

4
1

4
1

ProfessorAnhLe

4
1

104
1

Solvethisfory,wehave:y=8.55%.
Yieldtocall
Tocomputeyieldtocallofthiscallablebond,wewillmaketheassumptionthatthebondwillbecalled
withcertainty.Therefore,thecashflowsfromthebondwillbe:

Attime0.5:
Attime1.0:

$4
$4+$100=$104

Theyieldtocallofthebondwillthenbeysuchthat:
99

104

4
1

Solvethisfory,wehave:y=9.07%.
Yieldtoworst
Foracallablebond,yieldtoworstissimplytheminimumbetweentheyieldtomaturityandtheyieldto
call.Intheaboveexample,yieldtoworstissimplyminimumof(8.55%,9.07%)=8.55%.
Awordofcaution
LetsassumethatwegoouttoaBloombergterminaltocheckoutpricesofbondsofcomparablecredit
qualitytothecallablebondaboveandfindoutthefollowing:

A2yearnoncallablebondistradingatayieldof8.5%(orapriceof$99.10)
A1yearnoncallablebondistradingatayieldof8.4%(orapriceof$99.62)

Comparingthepricinginformationheretothatofthecallablebond,itseemsreallyweird.Fromour
calculations,

thecallablebondoffersayieldof8.55%ifitisheldtomaturity.Inthiscase,itscashflowsare
exactlythesameasa2yearnoncallablebondwhichoffersayieldofonly8.5%.
thecallablebondoffersayieldof9.07%ifitiscalledregardless.Inthiscase,itscashflowsare
exactlythesameasa1yearnoncallablebondwhichoffersayieldofonly8.4%.
inotherwords,worstcomestoworst,thebondearnsayieldtoworstof8.55%whichisstill
betterthaneitheroftheyieldsofferedbythe1yearor2yearnoncallablebond.

Itseemsthatthecallableoffershigher(thannecessary)yieldswhencomparedtothenoncallable.Putit
differently,thecallableissellingfor$99whichischeaperthanbothofthe1yearand2yearnon
callable.Whatisgoingon?Isthemarketnotfunctioningwell?Orarewemissingsomething?

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Itturnsoutthatifthemarketisfunctioningwell,thecallableoughttobecheaperthanboththe1year
aswellasthe2yearnoncallable.Toseewhythecallableshouldbecheaperthanthenoncallables,
letscomparetheircashflows:
time
0.5
1.0

1yearNon
callable
$4
$104

2yearNon
callable
callable
$4
$4
$4+Marketprice =$4+minimumof($100,market
attime1.0
priceattime1.0ofthe2yearnon
callable)

Thesecondcolumncontainscashflowsofthe1yearnoncallablewhichisquitestraightforward.The
thirdcolumncontainsthecashflowsofthe2yearnoncallableuptotime1.0.Thefirstcashflowisof
coursethe$4couponattime0.5.Tocomeupwithacashflowforthe2yearnoncallableattime1.0,I
assumewecollectthecouponof$4andsellthisbondattime1.0.Thecashflowattime1forthisbond
willbe$4+itsmarketpriceattime1.0.
Thelastcolumnofthetablecontainscashflowstothecallable.Nothingisspecialaboutthefirstcash
flowsimplyacouponof$4.Thecashflowattime1.0,however,iscrucialsincethisiswherethebond
issuercanexercisetheircallright.Letsseehowtheissuerofthecallablemakeshis/herdecisionattime
1.0.Itturnsouttobequitesimple.Sincethecallgivestheissuertherighttobuybackthe2yearnon
callablebondattime1.0forapriceof$100,itonlymakessensefortheissuertobuythe2yearnon
callablebackifitissellingformorethan$100attime1.0.Therefore:

Ifthemarketvalueofthe2yearnoncallableislessthan$100,theissuershallnotcallthebond
thecallablewillbethesameasthe2yearnoncallable.Inthiscase,thecashflowofthe
callableattime1.0willbethesameasthatofthe2yearnoncallable,whichislessthanthe
cashflowofthe1yearnoncallable.
Ifthemarketvalueofthe2yearnoncallableisgreaterthan$100,theissuerwillcallthebond
thecallablewillbethesameasthe1yearnoncallable.Inthiscase,thecashflowofthe
callableattime1.0willbethesameasthatofthe1yearnoncallable,whichislessthanthe
cashflowofthe2yearnoncallable.

Ascanbeseen,theissuersobjectiveistominimizehis/hercashflowobligationsofthecallablebond.
Therefore,byexercisingthecallfeatureoptimally,theissuermakessurethatthecashflowofthe
callableattime1.0willbetheminimumbetweenthoseofthe1yearnoncallableand2yearnon
callable.Inotherwords,comparedtoeitherofthenoncallable,thecallableentailsstrictlylessthanor
equalcashflows.Assuchitisobviousthatthecallablehastobecheaperthanboththe1yearand2
yearnoncallable.
4Valuationofacallablebond
Youagreethatthecallablebondaboveshouldsellforlessthanthe1yearnoncallableaswellasthe2
yearnoncallable,butexactlyhowmuchless?Ofcourseitiseasyifyouknowthemarketprice.Butwhat

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

ifthebonddoesnttradethatfrequent?Sothatyouknow,80%ofbondsnevertrademorethanoncea
year.Insuchinstances,tovalueacallablebond,ourmodelingknowledgebecomeshandy.Thisis
becauseitisquitestraightforwardtovalueacallablebondifwehaveaninterestratetree.Letsassume
wehavethefollowingtreeofsemiannualinterestrates.
0

0.5

1.5
15.44%

11.91%
9.19%
7.09%

11.44%
8.83%

6.81%

8.48%
6.54%
6.28%

Asyoumaynotice,therearesomecrazyinterestrates(like15.44%)inthetree,butthatsallright,every
tree,ifextendedlongenough,wouldgivethat.Importantly,probabilitiesforextremeoccurrencesare
quitesmall.Andalso,ourcurrentfocusisonhowtousethetreeforpricing,nothowreasonablethe
treeis.
Pricingofthe2yearnoncallable
Letsstarttoseehowwecanusethistreetopricethe2yearnoncallable.AndIpromisethatitisa
smoothtransitionfrompricingnoncallablebondstopricingcallablebonds.Rememberthatthecash
flowsfromthisbondareasfollows:

Attime0.5:
Attime1.0:
Attime1.5:
Attime2.0:

$4
$4
$4
$104

Topricethisbond,wewillofcoursedotheusualthingbywalkingbackwardsalongthetree,startingat
time1.5.

Attime1.5,wearenotsurewhatthepriceofthebondwillbe,butweknowthatthereare4
scenarios.Ifthe6monthinterestrateis15.44%,theprice(excludingthe$4couponattime1.5)
ofthebondwillsimplybe

96.55.Similarly,ifthe6monthinterestrateattime1.5is

11.44%or8.48%or6.28%,thevalueofthebondattime1.5wouldbe$98.37,$99.77,$100.83
respectively.
Letstakeastepbacktotime1.Attime1,thepriceofthebondcanbecomputedusingtherisk
neutralpricingequation.Forexample,ifweareinthehighestnodeattime1,thepriceofthe
bondwillbe

.
.

$95.75.The$4inthenumeratoris,ofcourse,thecouponthat

wewillreceiveattime1.5regardlessofwhereweare(goingupordown).Ifweareinthe

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

middlenode(orthelowestnode),bysimilarcalculations,thepriceofthebondwouldbe98.72
(or101.00).
Nowletstakeastepbacktotime0.5.Ifyouareintheuppernode(orlowernode),byvery
similarcalculations,thepriceofthebondwouldbe$96.79(or$100.44).
Finally,takeastepbacktothecurrenttimetime0.Applyingtheriskneutralpricingequation
onelasttime,thepriceofthebondis

.
.

$99.10.

Puttingthebondsvaluesateverynodeofthetreetogether,wewillhavethefollowingpricetree.This
pricetreecorrespondstotheinteresttreethatwestartwith.Thewayweinterpretthistreeisthesame
ashowweinterprettheinterestratetree.Forexample,weknowthepriceofthebondis$99.10now,
butwearenotsurewhatthepriceofthebondwouldbeattime0.5.Butweknowthatitcouldonlybe
either96.79or100.43withequalriskneutralprobabilitiesof50%.The96.79(100.43)pricecorresponds
tothescenariowheninterestrateis9.19%(6.81%)attime0.5.Andsoon,eachoftheprice/valuewe
seeherecorrespondstooneinterestratenodeweseeontheinterestratetree.
0

0.5

1.5
96.5451

95.75492
96.7878
99.10046

98.3727
98.716

100.4394

99.7719
101.0012
100.8344

OK,youunderstandwhyweneedaninterestratetreesimplybecauseitallowsustopricethebond
above.Butonceyouhavetheprice(attime0),isntthattheend?Whybotherputtingalltheprices
togethertobuildtheabovepricetree?Whatpurposedoesitserve?Itturnsoutthat,fromtheabove
tree,thepriceofthe2yearcallablebondisonlyafewcalculationsaway.Letsnowturntohowwecan
usethetreetopricethe2yearcallablebondwithacallpriceof$100.
Pricingofthe2yearcallable
Inpricingthe2yearcallable,thekeyisjusttorememberthatattime1theissuerofthecallablewill
optimallyusehis/hercallright.

Attime1.5,ifthecallablehasnotbeencalled,itwillbethesameasa2yearnoncallablebond.
Assuch,thevaluesofthecallableandthenoncallablemustbeidenticalateverynodeofthe
treeattime1.5.
Attime1.0,theissuermaycallthebond.However,theissuerwillcallthebondonlyifthevalue
ofthebondishigherthanwhatheneedstopayincallingit:$100.Checkingthe3scenariosat
time1,itonlymakessensefortheissuertobuybackthebondifthevalueofthebondis
$101.00.Paying$100forthebond,effectivelytheissuernets$1.00thankstothecallfeatureof

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

thebond.Onthecontrary,itwillnotmakeanysensefortheissuertocallbackthebondifits
totalvalueiseither95.75or98.72.Insuchinstances,itisbetterfortheissuertoleavethebond
uncalled.Topricethecallable,therefore,requiresonemodificationinthebondvalueattime1
onthelowestnode.Insteadof101.00,sincetheissuerwouldoptimallycallthebondhere,the
valueofthecallableshouldreallybe$100atthisnode.Thismodification,inturn,willlowerthe
valueofthecallableattime0.5(lowernodeonly)andultimatelythepriceofthecallableat
time0.
Steppingbacktotime0.5,thetotalvalueofthebondattheuppernoderemainsunchanged.
Thetotalvalueofthebondatthelowernodehoweverwillchangeto

.
.

$99.96.
Finally,letstakethestepbacktotime0.Thepriceofthecallablewouldbe:
.

.
.

$98.87.

Puttingallthevaluesthatwejustcalculatedaboveinatree,wehave:
0

0.5

1.5
96.5451

95.75492
96.7878
98.86668

98.3727
98.716

99.9552

99.7719
100
100.8344

Notethatthedifferencestothetreeofnoncallablebondpricesarehighlightedwiththebluecolor.
Thesearethenodesthatareaffectedbythebondsbeingcalledattime1.Notethatthesenodes
correspondtothelowestbranchofthetreewhereinterestratesarelow.Thismakessensebecause,as
weknow,bondsarebestcalled/refinancedwheninterestratesarelow.
Pricingofthe2yearcallableWhatifthebondiscallableattime1.5aswell?
Ialwaysliketostartthingsoutsimple.ThatswhyIveillustratedhowtopricethecallablebond
assumingthatwecanonlycallthebondattime1.Youcanaskthequestionofwhatifthebondcanbe
calledattime1.5aswell.Infactmanybondsallowformultiplecalldates.Further,whatifatdifferent
calldates,wehavedifferentcallprices?Fortunately,thoughmorecomplicated,alltheseconcernscan
beaddressedusingthesameframeworkthatwevejustgonethrough.
Letsconsiderthesamecallablebond:face$100,semiannualcouponof8%,butnowcallableeitherat
time1withacallpriceof$102orattime1.5withacallpriceof$100.Thekeytopricingthisbondis
simplytostartwiththepricetreeofthenoncallable,andthencheckattime1.5and1,whetherit
makessensetocallthebondatanyofthenode.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

First,letscheckifitsoptimaltocallthebondattime1.5.Rememberthatthecallpriceattime1.5is
$100.Ifhe/shedoesntcallthebondanddecidestoletthebondliveuntilmaturity,thebondsvaluewill
bethesameasthatofitsnoncallablecounterpart.Assuch,startingwiththepricetreeforthenon
callablebondandfocusonitsvalueattime1.5,wewillbeabletotellwhentheissuerwouldcallthe
bond:onlywhenthevalueofthebondexceeds100.
0

0.5

1.5
96.5451

0.5

95.75492

1.5
96.5451

95.75492

96.7878
99.10046

96.7878

98.3727
98.716

99.10046

100.4394

98.3727
98.716

100.4394

99.7719
101.0012

99.7719
101.0012

100.8344

100

Thetreeontheleftisthetreeofnoncallablebondprice.IfyouarewonderingwhereIgotthetree
from,Ijustcopiedandpastedfromabovewhenwewerepricingthenoncallablebond.Ifyoualready
forgothowwegotthesenumbers,pleasegobackandseemydetailedcalculationsupthere.Fornow,I
onlypaintorangethenodesattime1.5tohighlightthefactthatweareonlycheckingwhetheritis
callableattime1.5.
Examiningthe4possiblescenariosattime1.5,itiseasytoseethattheissuerwillonlycallthebondat
thelowestnodewherethevalueofthebondifletalive(untilmaturity)is$100.8344.Assuchforthe
treeontheright,Ireplacethevalueofthebondatthelowestnodeby100andpaintthenodeblueto
showthatthebondwouldbecalledifwegettothisnode.
Sothatisdoneattime1.5.Thesecondthingwewouldliketodoistogobacktotime1andcheckifitis
optimaltocallthebondanywhereattime1.Youmaybethinking:easystuffweddothesamething
again,checkingforallpossiblescenariosattime1andcomparingthevalueofthenoncallablebondto
thecallprice.Ifyouthinkso,thatwouldbetoofast!Beforewegettothatstage,weneedtoadjustthe
bondvaluesattime1toreflectthechange(s)wehavemadetothetreeattime1.5.
Specifically,rememberhowwegetthevalueof101.0012atthelowestnodeofthetreeattime1?Itis
simplytheriskneutralexpectedcashflowsdiscountedattheriskfreerateof6.54%.Attime1.0,ifyou
areinthelowestnode,weknowthatthevalueofthebondwouldbeeither99.7719or100.8344.As
such,thevalueofthebondincludingthecouponwouldbe:

.
.

$101.0012.Thatis,

forthenoncallablebond.Nowforthecallable,wealreadyworkoutthatifthevalueofthebondis
100.83attime1.5,theissuerwillcallthebond.Assuch,thevalueofthebondthebondonthelowest
nodeattime1.0wouldbe:

.
.

$100.60.

AdvancedFixedIncome
0

CallableBonds

0.5

1.5
96.5451

ProfessorAnhLe

0.5

1
95.75492

95.75492
96.7878
99.10046

96.7878

98.3727
98.716

100.4394

98.3727

99.10046

98.716
100.4394

99.7719

99.7719

101.0012

100.6
100

1.5
96.5451

100

Onlyafteradjustingthenodesofthetreeattime1asshownabove,wecanproceedandcheckwhether
itisoptimalfortheissuertocallthebondattime1.Rememberthatthecallpriceattime1isdifferent.
Itis$102.Examiningtheupmostnodeofthetreeattime1,thetotalvalueofthebondisonly$95.75.It
isthereforenotworthtopay$102forthebondatthatnode.Similarly,fortheothertwonodesattime
1,itturnsoutthatitisnotoptimalfortheissuertocallthebondeither.Youcanseethatthisissimply
duetothehighcallprice($102)attime1.Ifthecallpriceattime1werestill$100,theissuerwould
optimallycallthebondatthelowestnodewherehe/shewouldpay$100forthebondthatisworth
$100.6.
Now,goingbacktotime0.5,weneedtoadjustthevalueofthebondatthelowestnodeattime0.5as
well.Thismodificationisnecessaryduetothechangeswemadetothevaluesofthebondsattime1.
Thetotalvalueofthebondatthelowestnodeattime0.5shouldbe:
Similarly,goingbacktotime0,thevalueofthebondshouldbe:
0

0.5

1.5
96.5451

.
.

.
.

0.5

95.75492
96.7878
99.10046

1.5
96.5451

95.75492

98.716

99
99.7719

100.6

$99

96.7878

98.3727

100.4394

$100.24.

98.3727
98.716

100.24

99.7719
100.6

104

104

5Spreadsduetooptionality
Letstakeastepbackandthinkaboutallthatwehavedone:seemingly,allofasudden,wepricebonds
usingtreesofinterestrates!Alotofcalculationsmakeusmissdearlythesimplediscountingexercises
thatweusedtodo:allweneedisjustayieldcurveandthenwewilljustdiscount1yearcashflows
usingthe1yeardiscountrate,2yearcashflowsusingthe2yeardiscountrateandsoon,allweneedto

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

careaboutistheconsistencybetweenthetimingofthecashflowsandthehorizonoftheinterestrates.
Allweknowis:allofasudden,lifegetssocomplicated!Canwegetbacktothesimplediscounting
calculations?
Alright,letsdothat.Fromthetreethatwestartwith(whichIputbelowtosaveyoutimeflippingback
thepages),Icancomputetheinterestratesfordifferenthorizons.

0.5

1.5
15.44%

Horizon Interest
0.5
7.09%
1
7.54%
1.5
8.03%
2
8.55%

11.91%
9.19%
7.09%

11.44%
8.83%

6.81%

8.48%
6.54%
6.28%

Iassumethatallofyouknowhowtocalculateinterestratesofdifferenthorizonsfromaninterestrate
tree.Andassuch,Iwontshowthedetailsofmycalculationshere.However,ifyouarewonderinghowI
gottheaboveinterestrates,youshouldgobacktomynotesonInterestRateModels.
Pricingofthenoncallablebond:
Giventheaboveinterestrates,inordertopricethe2yearnoncallablebond,allweneedtodoisto
discountitscashflowsusingtheappropriateinterestrates:

4
7.09%
2

4
1

7.54%
2

4
1

8.03%
2

104
1

8.55%
2

$99.10

Youcanseethattheprice,$99.10,matcheswhatwegotbeforefromtheinteresttree.
Pricingofthecallablebond:
However,whenitcomestopricingthecallablebond,withoutthetree,wearestuck!Fromourearlier
calculations,weunderstandthatthepriceofthecallableislowerthanthepriceofthenoncallableand
shouldbe$98.87.Butitseemsthat,withouthavingthetreetodeterminewhenitisoptimaltocallthe
bond,wewontbeabletoarriveatthisprice.
Sometraders,however,dontliketocarryabulkytreearound.Theyprefertheeasinessofthefamiliar
discountingexercises.Assuch,theydecidetodothefollowing:sincetheyknowthecallable(duetoits
callability)willbecheaperthanitsnoncallablecounterpart,inordertopricethecallablebond,they
willaddaspreadtothediscountratesusedtopricethenoncallable.Letssaythespreadis13basis
points.Thepriceofthecallablebondwillbe:

AdvancedFixedIncome

4
7.09%

CallableBonds

ProfessorAnhLe

4
2

0.13%

7.54%

1
104

8.55%

4
2

0.13%

0.13%

8.03%

0.13%

$98.87

whichexactlymatchesthepriceofthecallablebondwehaveabove.IamsureyouknowhowIcomeup
withsuchaspreadthatgivestheexactpriceof$98.87Solver,whatelse?
Oncewehavethisspread,itisseeminglyconvenientbecausewecanthencarrythespreadaroundand
priceothercallablebondsbyaddingthesamespreadtotheirdiscountrates.Thispracticeisdangerous,
however,sincethevalueofacalloptionisdifferentfrombondtobonddependingontheircoupon
rates,theircallpriceetc.Assuch,pleasebecarefulifyoueverdothisatwork.Ifyoutreasuresafety,I
wouldrecommendusinganinterestratetree.
6Zerovolatilityspread(orZspreadorstaticspread)
Wehavebeenusingtheriskfreeinterestratetreetopricethesetwobondswiththeimplicit
assumptionthattheycomewithoutdefaultrisk.Thisisnotreasonable.Infact,accountingfordefault
risk,liquidityrisketc.,pricesofthebondswouldbelowerthanwhatwehadpreviously.Letsassume
thatbecauseofthesefactors(defaultrisk,liquidityrisk),thecallableisonlysellingfor$97.33insteadof
$98.87.Tolookforaspreadforthisbond,weagainchooseanumbersthatwhenaddedtotheriskfree
discountrateswillrecoverthemarketpriceof$97.33.
$97.33

4
7.09%
2

4
1

7.54%
2

4
1

8.03%
2

104
1

8.55%
2

UsingSolver,Ihaves=100basispoints.Notsurprising!Fromthelastsection,evenwithoutcreditand
liquidityrisk,andjustduetooptionality,wealreadyhaveapositivespreadof13basispoints.Nowthe
bondhasmorerisksattachedtoit,thepriceisreducedtoreflecttheextrarisks,assuchthespread
shouldbelargertoaccountfornotonlytheoptionalityofthebondbutalsothecreditandliquidityrisks
associatedwithit.
Thisspreadiscalledthezerovolatilityspreadorthezerospreadorthezspreadorthestaticspreadof
thebond.Nowzspreadorzerospreadisjustashortformforzerovolatilityspread.Whyisitcalled
zerovolatilityorstaticspread?Well,itisstaticrelativetootherspreadsthatcomeofftheinterestrate
treethatwewouldconsiderinthenextsection.Looselyspeaking,aspreadthatcomesoffabulkytree
seemsmoredynamic.Likewise,withatree,we,sortof,seethevolatilityofinterestrates.Ifthetreeis
fat,interestratesarevolatile,ifitisthin,interestratesarestable.Assuch,aspreadthatcomesfrom
justtheriskfreeinterestrates(likewhatwehavehere)asopposedtoonethatcomesoffatreelacks
thevolatilityelement,henceiscalledzerovolatilityspread.
Namingbusinessaside,twothingsareimportantaboutstaticspreads:

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Ittakestheshapeoftheyieldcurveintoaccount(sinceitisaconstantspreadaddedtoeachof
thediscountrateforeachmaturityweneedayieldcurvetocomputethespread)
Itissomesortofatotalspreadsinceitincludeseverything:someelementofoptionality,some
elementofcreditrisk,someelementofliquidityrisketc.

7Optionadjustedspread
Optionadjustedspreadisanimportant(thoughpotentiallyconfusing)conceptoftenusedincontextsof
callablebond,mortgage,mortgagebacksecuritiespricing.
Tounderstandoptionadjustedspreadaswellaswhyithassuchaname,thinkaboutthefollowing
situation:Weobservethepriceofthecallablebondtobe$97.33andwewouldliketousethis
informationtomakesomeinferencesregardingthepriceofanidenticalbondissuedbythesame
issuerexceptthatitisnoncallable.Imaketheprevioussentenceboldtoshowthatitisimportantto
bearthiscontextinmindinbetterunderstandingtheconceptofoptionadjustedspread.
Alright,fromthecalculationsintheprevioussection,weknowthatthezspreadofthecallablebondis
100basispoints.But,ofcourse,wecantusethisspreadtopricethenoncallablebecausethezspread
ofthecallablebondincludeseverything.Itincludesnotonlycreditrisk,liquidityriskbutalsothe
optionalityofthecallablebond.Whilethepartofthespreadthataccountsforcreditriskandliquidity
riskshouldbethesameforboththecallableandnoncallablebonds,thenoncallablebondhasno
optioninit.Assuch,itwouldbeunfairtopricethenoncallablebondusingaspreadthatincludessome
optionalitycomponentinit.
Naturally,therefore,wewouldliketotakeawaythepartthatisduetooptionalityofthecallableand
usetheremainingparttopricethenoncallablebond.Thismakessensebecauseifyoutakeawaythe
optionalitycomponentfromthecallableszspread,theremainingspreadmustbeduetocreditrisks
andliquidityriskswhicharethesameforboththecallableandnoncallable.Thisspreadiscalledthe
optionadjustedspread.Thenamederivesfromthefactthatwestartfromthestaticspreadofa
callableandinordertopricethenoncallable,weneedtoadjustthespreadfortheoptionality
componentinit.Totieeverythinginanequation,wehave:
Staticspread=optionadjustedspread+spreadduetooptionalityofthebond
Buthowwouldwedothat?Howcouldwedisentangletheoptionandnonoptioncomponentsofthe
staticspreadofthecallablebond?Theanswer:Weneedaninterestratetree.Youmayhaveawhya
treequestionrightnow,butletmedeferansweringthatquestionlater,letmeshowyouhowwefind
theoptionadjustedspreadfromatreefirstandthenexplainwhylater.
Firstofall,theinteresttreethatweusedbeforeisnolongerappropriate!Thattreewasdefaultfree.
Nowthatourbondsaresubjecttodefaultrisksandliquidityrisks,weneedtodiscounttheircashflows
heavier.An dweneedtodothatateverynodeofthetree.Thissuggeststhatweneedtoaddaspreads
toeachoftheinterestratesinthebinomialtree.Thatway,wewoulddiscountthebondscashflows
heavierateverynode.

AdvancedFixedIncome

CallableBonds
15.44%

ProfessorAnhLe

15.44%+s
11.91%+s

11.91%
9.19%
7.09%

9.19%+s

11.44%
7.09%+s

8.83%
6.81%

6.81%+s

8.48%

8.48%+s
6.54%+s

6.54%
6.28%

11.44%+s
8.83%+s

6.28%+s

Inlookingfortheoptionadjustedspreadofthecallablebondwhichissellingatt$97.33,Iwillchoosea
spreadsinawaythatwhenIusetheresultingtree(ontherightabove)topricethecallable,itwould
recoverthemarketvalueofthecallablebond(at$97.33).Asusual,thisprocesscanonlybedonebytrial
anderrorwhichcanbeautomatedbytheSolverfunctioninExcel.
IwillleavetheSolverparttoyou.Fornow,tofurtherillustratehowtheprocessworks,letstrya
randomvalueofs=99basispoints.Ifits=99basispoints,wewillhaveanewtreeofinterestratesthat
accountsfordefault/liquidityrisksofthebond.Thetreewillbeasfollows:
0

0.5

1.5
16.43%

0.5

8.08%

95.48639

12.43%
97.33178

9.82%
7.80%

1.5
96.1034

94.8869

12.90%
10.18%

9.47%

97.9142
97.807

99.0416

99.3003
100

7.53%
7.27%

100.3528

Uponhavingthetree,wecanusethetreetopriceourcallablebondfollowingtheusualprocess.Tosave
spaceandtime,Iwillnotshowthedetailsofthepricingprocess.Rather,Ijustincludeherethefinaltree
ofbondvalues.Ifyoulike,youcandoallthepricingcalculationsyourselfandcheckyouranswers
againstmine.Ifyouarenotsurehowtopriceacallablebondusinganinterestratetree,pleasereferto
section4ofthisnode.Inpricingthebond,rememberthatthisbondhasafacevalueof$100,paying
semiannualcouponrateof8%andcanbecalledforacallpriceof$100attime1.0andtime1.0only.
NotethatIpaintblueallthenodesthatneedadjustmentsduetothecallfeatureofthecallablebond.
Amazingenough,withaspreadof99basispoints,weindeedrecoverthemarketpriceofthecallable
bondwhichis$97.33.Ok,soIcheated.Isaidletstryarandomvalueofs=99basispoints.Thevalue
of99basispointsIchosetotrywasnotrandom.IusedSolverinExcelandworkedoutthats=99basis
pointswouldgivemethepriceofthecallablebondthatIwant($97.33).
Hopefully,bynowyouunderstandatleastinatechnical,mechanicalsensehowtocomputetheoption
adjustedspreadfromtheinterestratetree.(AndasImentionearlier,comparedtothestaticspread,
thisoptionadjustedspreadseemsmoredynamic,lessstaticflavorsinceitcomesoffatree.)Still,you

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

maybewonderingwhysuchaprocedurewouldgiveustheexactspreadthatwewanttheoption
adjustedspreadthespreadthathasnooptioncomponentinit.
Fairenoughletmeexplainit.
Inexplainingit,Ifindithelpstolookbackandseehowthingsmovealong.First,wepricethenon
callabledefaultfreebondtobe$99.10.Second,weshowthatifthebondbecomescallable,thecallable
defaultfreebondshouldbepricedatalowervalueof$98.87,areductionof$0.23.Finally,ifweallow
forthefactthatthebondisdefaultable,thepriceofthecallabledefaultablebondshouldbeevenlower
at$97.33,anadditionalreductionof$1.54.
Itisimportanttorecognizethat,inusingthetree,thetworeductionsinbondpriceoccurindifferent
manners.

Toaccountforthecallabilityofthebond,weadjustdownwardsthevaluesofthebondsattime
1.0atnodeswhereitisoptimalfortheissuertocallthebond.Thisisbecausetheissuerofthe
callablebondwilloptimallycallthebondwheneverthevalueofthebondisgreaterthanthecall
pricehe/shehastopayincallingthebond.Itisimportanttounderstandthatallwedohereisto
adjustthecashflowsdownwards.Weneverhavetomodifyourinterestratesateachnodeof
thetreetoaccountforthecallabilityofthebondbecauseitisunnecessary.
Toaccountfordefault/liquidityrisks,unlikehowweallowforcallability,wedontforcibly
modifythecashflows.Instead,wesimplydiscountthecashflowsheavier.Thisinvolvespushing
upourinterestratesateachnodeofthetreebyapositivespread.

Ifyoucanthinkofpricingasgenerallydividingexpectedfuturecashflowsby(1+thediscountrate),or
,thelooselyspeaking,thefirstpricereduction(toaccountforthe
bondscallability)occursthroughareductionoffuturecashflows(areductioninthenumerator).Onthe
otherhand,thesecondpricereduction(toaccountforthebondsdefault/liquidityrisks)occursthrough
anincreaseinthediscountrate(anincreaseinthedenominator).

CF

Pushingthe
wholetreeup

Adjustingcashflowsdown
whenthebondiscalled
Howtoadjustforcallability

Howtoadjustforcreditrisks/liquidityrisks

Sincewealreadyaccountforthecallabilityofthebondbyadjustingthecashflowsdownwheneverthe
bondiscalled,thespread(99basispointsintheaboveexample)weaddtotheriskfreeinterestrate

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

treehasnothingtodowiththecallabilityofthebond.Inotherwords,suchaspreadbywhichwepush
thewholetreeupinpricingthecallableonlyaccountsforthecreditrisksandliquidityrisksofthe
callablebond.Therefore,thespreadof99basispointsthatwefoundaboveistheoptionadjusted
spreadthatweneedaspreadwithouttheoptionalitycomponent!
Oncewefindtheoptionadjustedspread,wecanuseittopricethenoncallablebondsincewewould
haveanewinterestratetreethatallowsforthecredit/liquidityrisksofthebondissuer.
0

0.5

1.5
16.43%

0.5

12.90%
10.18%
8.08%

9.82%

95.48639
97.34568

9.47%
7.53%

97.9142
97.807

99.0705

99.3003
100.0601

7.27%

1.5
96.1034

94.8869
12.43%

7.80%

100.3528

Usingthetreetopricethenoncallablebondshouldbestraightforwardandevensimplerthanpricing
thecallablebondbecausewedontevenhavetocheckforwhenitisoptimalfortheissuertocallthe
bond.Again,Iwontgothroughthedetailsofthepricingprocesshere.Rather,Iwouldputherethe
resultingpricetreeforyoutocompareyourcalculationsto.
Accordingtomycalculations,thefinalpriceofthenoncallablebondis$97.35,justslightlyabovethe
priceofthecallablebondat$97.33.Thismeansthatthevalueofthecallablefeatureisonly$0.02?Orin
otherwords,ifwegobacktoourequation:
Staticspread=optionadjustedspread+spreadduetooptionality
Sincetheoptionadjustedspreadis99basispointsandthestaticspreadis100basispoints,thespread
duetooptionalityisreallysmall:10099=1basispoint!Thisiscrazy!Duetoourcalculationsearlier,the
spreadduetooptionalityis13basispoints(remember?).Whathappenstoitthatreducesitby13fold?
Answer:theextracredit/liquidityrisks.Butwhy?
Ifthefirmhascreditrisks/liquidityrisks,itsbondshouldgenerallysellforlesscomparedtothecase
whenithasnocreditorliquidityproblems.Thisshouldbetrueateverynodeofthetreebecauseto
accountforcredit/liquidityrisks,weneedtousehigherdiscountratesateverynodeofthetree.To
betterillustratethis,Iwillputthepricetreeofthenoncallablebondwithandwithoutcredit/liquidity
riskstogetherandhopefullyyoucanhaveasenseofwhatImean.Justcomparinganypairof
correspondingnodes,youwouldseethatthevalueofthedefaultablebondisalwayslessthanits
defaultfreecounterpart.

AdvancedFixedIncome

CallableBonds

Defaultfreenoncallablebond
0
0.5
1
1.5
96.5451
95.75492
96.7878
98.3727
99.10046
98.716
100.4394
99.7719
101.0012
100.8344

ProfessorAnhLe

Defaultablenoncallablebond
0
0.5
1
1.5
96.1034
94.8869
95.48639
97.9142
97.34568
97.807
99.0705
99.3003
100.0601
100.3528

Asaconsequence,thevalueofthecalloptiontotheissuerofthedefaultablecallablebondwillbe
smaller.Thisshouldbeclearbylookingatthelowestnodeattime1wheretheissuerofthetwobonds
willcall(becausethevalueofthebondhereisgreaterthan$100)andcomparingthevalueofthecallto
eachissuer.Theissuerofthedefaultfreebondpocketsthedifferenceof$1.00012betweenthevalueof
thebond(ifletalive)andwhathehastopayincalling($100).Ontheotherhand,theissuerofthe
defaultablebondearnsonly$0.0601.
Anotherwayofthinkingaboutthisis:relativetothedefaultfreecase,ifyouhavetheextra
credit/liquidityrisksandthushavetofacerelativelyhigherborrowingcosts,youwillbelesslikelytocall
thebondthesamewayyouwillbelesslikelytorefinanceyourmortgageifthecurrentinterestrates
arehigh.Ifyouarelesslikelytocallthebond,itsvalueshouldbesmaller.
Andifthevalueofthecallablefeaturebecomessmaller,naturallythespreadduetooptionality
becomessmalleraswell.Thisexplainswhythespreadduetooptionalityhasdecreasedfrom13basis
pointsincaseofnodefault/liquidityrisksto1basispointwhenweallowforcredit/liquidityrisks.
Assomefinalwordsofcaution,theoptionadjustedspreadmeasuresthatwelearnsofararemodel
dependent.Inotherwords,weneedsomeinterestratetreesomemodelofinterestratetocalculate
thismeasure.Wheneverwetalkaboutmodel,thereisoneextradimensionofrisk,namelymodelrisk.
Assuchtobeprecise,theoptionadjustedspreadcontainscredit/liquidityrisksaswellasmodelrisks.
Thepartsrelatedtocredit/liquidityrisksshouldbepositive!However,thepartrelatedtothemodel
risks,itcouldbepositiveornegativedependingonhowweconstructthemodel.
8Callablebondpricesandinterestrates
AsIalreadymentionedintheintroclass,bondpricesandinterestratesareliketwoendsofaseesaw.
Wheninterestratesgoup,bondpricesgodownandviceversa.Thesameanalogyappliestothe
relationshipbetweencallablebondpricesandinterestrates.Ifyouplotthepriceofthe2yearcallable
bondconsideredearlieragainstinterestrates,youwillhaveanegativelyslopedgraphasyouwouldfor
otherbonds.
However,asIshowedabove,sincethe2yearcallableisboundedfromabovebypricesofthe1year
noncallableaswellasthe2yearnoncallable,thepricingfunctionofthe2yearcallablebondwilltakea

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

somewhatspecialshape.Inthegraphbelow,Iplotthepricingfunctionofthe2yearcallablebond(in
purplecolor)togetherwiththatofthe1year(inredcolor)and2year(inbluecolor)noncallablebonds
forcomparisonpurposes.

Wheninterestratesarereallyhigh,borrowersarelesslikelytorefinancetheirborrowings.Inother
words,therearehighchancesthattheissuerwillletthebondliveuntilmaturitywithaveryhigh
probability.Inthesecases,thecashflowsfromthecallableareverymuchsimilartothosecomingfrom
the2yearnoncallablebond.Thisexplainswhytheshapeofthepurplegraph(callablepricingfunction)
comesveryclosetothatofthebluecurve(2yearnoncallablepricingfunction)asinterestratesrise.In
theotherextreme,wheninterestratesarelow,borrowersarehighlylikelytorefinancetheir
borrowings.Iftheissuercallsthe2yearcallablewithaveryhighchance,thecashflowsfromthe
callableareverymuchlikethosecomingfromthe1yearnoncallable.Thisexplainswhythepurple
graphcomesveryclosetotheredgraph(1yearnoncallablepricingfunction)asinterestratesgoreally
low.
Wecanseethatasinterestratesdecrease,thepricingwedgebetweenthe2yearcallableand2year
noncallablebecomesmoreandmorepronounced.Thisdifferenceispreciselyduetocallablefeature
attachedtothecallablebond.Thisdifferenceisthevalueofthecallabilityofthebond.Inaddition,we
canseefromthegraphthatgivenareductionininterestrates,bondswouldgenerallyappreciatein
values.However,duetothecallablefeature,theextenttowhichcallablebondspricesincreaseismuch
lessthanthatforthe2yearnoncallable.Thisphenomenonisreferredtoaspricecompression.
Finally,intheintermediaterangeofinterestrates,thepricingfunctionofthecallabledisplaysa
negativelyconvexshape.Ifweareworriedsinceyouarenotsurewhatnegativeconvexitymeans,dont
worrywewilltacklethatwithmoredetailsshortlyinthenextsection.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

9Duration/dollardurationandconvexity/dollarconvexityofcallablebonds
Beforetalkingabouteitherdurationordollardurationofcallablebonds,Iwouldliketoremindyouof
howIshowed,inourintroclass,thatthedollardurationofbondsissimplytheslopeofthetangentline
ofthepricingfunction.Afterall,(dollar)durationmeasuresthesensitivityofbondpricewithrespectto
changesininterestrates.Iftheslopeofthetangentlineissteep,agivenchangeininterestratewilllead
toalargechangeinbondprice.Ontheotherhand,whenthetangentlineisratherflat,agivenchange
ininterestrateswillonlycauseasmalldeviationinbondprices.
Itturnsoutthatdollardurationaswellasdurationofregularbondsdecreaseasinterestratesincrease.
Whyisthat?Justthinkofhowyoucomputedurationofazerocouponbond:

whereTismaturity

andyisthesemiannualinterestrate.Obviously,asinterestrates(y)increase,durationgoesdown.
Graphicallyspeaking,aswemovealongthepricingfunctionofregularbonds(likewhatwehavebelow
onthelefthandside),theslopeofthetangentlinegraduallydecreasesthebondbecomeslessand
lesssensitivetochangesininterestrates.
Positiveconvexity

Negativeconvexity

Itispreciselythisdecreaseindurationasinterestratesincreasethatgivesrisetopositiveconvexityfor
theregularbonds.TocontrastbetweenpositiveconvexityandnegativeconvexityIalsoincludeonthe
righthandsideanexampleofnegativeconvexity.Thereyouseethatasinterestratesincreasethe
tangentlinesbecomesteeperandsteeper.
Anotherinterestingobservationisthat:

Withpositiveconvexity,thebluecurvealwaysliesabovethetangentlines.Ifyouremember
wellthedurationandconvexityapproximation,thedifferencebetweenthebluecurveandthe
redtangentlineispreciselywhatourconvexityadjustmentsgoafter.Ifthebluecurvealways
liesabovetheredline,thisexplainswhyourconvexityadjustmentisalwayspositivehencethe
namepositiveconvexity.
Withnegativeconvexity,thebluecurveinsteadalwaysliesbelowthetangentlines.Thistime,
thedifferencebetweenthebluecurveandtheredlineisalwaysnegative.Assuchtheconvexity
adjustmentforthiscasewillalwaysbenegativehencethenamenegativeconvexity.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Letsnowgetbacktoour2yearcallablebondandthinkaboutitsdollardurationandhowitwillchange
asinterestratesincrease.Forillustrationpurposes,Iplotonagraphherethe$durationofthe2year
noncallable(inblue)andthe$durationofthe1yearnoncallable(inred)togetherwiththe$duration
ofthecallablebond(inpurple).Youcanseethatthe$durationofthe2yearnoncallableand1year
noncallabledecreaseasinterestratesincreaseasIexplainedabove.Inaddition,$durationofthe2year
noncallableisalwayshigherthan$durationofthe1yearnoncallable.Thismakessensesincefora
longermaturity,the2yearnoncallableshouldbemoresensitivetointerestratechangesthanthe1
yearnoncallable.Letmeknowexplaintheshapeofthepurplegraphwhichtellsushowthe$duration
ofthecallablechangesasinterestrateschange.

Forreallylowinterestrates,borrowersarelikelytorefinancetheirborrowingsequivalently,
therearehighchancesthe2yearcallablebondwillbecalled.Therefore,forverylowinterest
rates,the2yearcallablebondbehavesverysimilarlytothe1yearnoncallable.Assuch,forthe
lowrangeofinterestrates,theduration/dollardurationofthe2yearcallablewilllookvery
muchlikethatofthe1yearnoncallable.Inotherwords,thepurplegraphshouldcomereally
closetotheredlinewheninterestratesarereallylow.
Forreallyhighinterestrates,borrowersarealmostcertainnottorefinanceorinotherwords,
therearehighchancesthatthe2yearcallablewithliveuntilmaturity.Assuch,forthehigh
rangeofinterestrates,theduration/dollardurationofthe2yearcallablewilllookverymuch
likethatofthe2yearnoncallable.Inotherwords,thepurplegraphshouldcomereallycloseto
thebluelinewheninterestratesarereallyhigh.
Fortheintermediaterangeofinterestrates,wedontknowexactlyhowthepurplegraphwill
turnout.However,onethingweknowforsureisthatthepurplegraphshouldbecontinuous.
Togetfromwhereitiswheninterestratesarelow(closetotheredline)towhereitiswhen
interestratesarehigh(closetotheblueline),therefore,meansthat$durationofthecallable
bondwillincreaseasinterestratesincreaseatleastforsomeintermediaterangeofinterest
rates.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Asexplainedabove,thisbehaviorofduration(increasewheninterestratesincrease)creates
negativeconvexity.ThisisexactlywhatweseefromthefigureIincludeinsection8,whichIwillput
hereagaintosaveyoutimeflippingback:

Onewaytothinkabouthowthisnegativeconvexitycomesaboutistoimaginethatyouaredriving
alongtheredcurveandapproachingwhetherthebluecurveandtheredcurveinterests.Thenyou
wanttomakearightturnintothebluecurve.Whenyouaremakingarightturn,aslongasyouare
notgoingdeadlyslow,youwillmakeabendingshapesimilartothepurplegraphthatwehave,
whichisnegativeconvexity.
Afterall,whatisthedealaboutnegativeconvexity?Whyisitsoimportantthatwehavewasted
quitesometimetalkingaboutit?Itturnsoutthatithasquiteimportantimplicationsinhedging,
especiallyforthosecompaniesthatinvestinfixedratemortgagesthat,asyouwillseelateron,also
displaynegativeconvexity.Inminimizingtheirexposuretointerestraterisks,naturallythesefirms
wouldliketobalance/matchthedurationsandconvexitiesoftheirassetsandliabilities.Therefore,if
theyhavenegativeconvexityassets,theywouldliketohavenegativeconvexityliabilitiesthatgive
themanaturalhedge.Andonewaytohavenegativeconvexityliabilitiesistoissuecallablebonds.
10ComputationofDuration/dollardurationandconvexity/dollarconvexityofcallablebonds
Asyoualreadysee,unfortunately,durationandconvexitymeasuresofcallablebondsarequitedifferent
fromthoseofthemoreregularbonds.Duetothis,allthetechniquesthatwelearnincomputing
durationandconvexityfortheregularnoncallablebondsarenolongerapplicablehere.Iwillfirstshow
youtheprocessbywhichwecancomputethe(dollar)durationofthe2yearcallablebond.Next,Iwill
showyouhowtheconvexitycanalsobecomputed,usingasimilarprocess.Thesedurationand
convexitymeasuresarecalledeffective(dollar)durationandeffective(dollar)convexitytodifferentiate
themfromtheothermeasuresthatwehavelearnt.Forthesakeofbrevity,inwhatfollows,Iwillomit
thewordeffectiveinfrontofdurationandconvexitywiththeimplicitassumptionthatyouunderstand
thatIrefertoeffective(dollar)durationsand(dollar)convexity.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

(Dollar)Duration:
First,Imentionedearlier,dollardurationistheslopeofthetangentlinetothepricingfunctionofany
bond,callableornoncallable.Fornoncallableregularbonds,fortunately,wehaveformulas.With
callablebonds,however,wedonthavethatluxury.Tocompute(dollar)durationforacallablebond,we
needtogothroughasetofstepsthatturnouttobeapplicabletoeverybond:
1. First,wecomputethecurrentvalueofthebondatthecurrentlevelofinterestrates.Letssay
thecurrentvalueofthebondisV0.
2. Second,weincreasetheinterestratelevelbyasmallamounty.Howsmall?Somethingsmaller
than10basispointswouldbesmall.Wethencomputethevalueofthebondatthisnewlevelof
interestratesandcallitV+.
3. Third,wedecreasetheinterestratelevelbythesamesmallamountyandcomputethevalue
ofthebondatthisnewlevelofinterestratesandcallitV.
4. Dollardurationofthebondwouldbe
5. Durationofthebondwouldbe

.
.

Iwillnowexplainwhythesestepsmakesense.Myexplanation(thoughshortandintuitive)onlyserves
thepurposeofsatisfyingthosecuriousaboutthereasoningbehindthesesteps.Itwontbeonthetest.
Assuch,thoseofyouwhothinkthatitistoomuchtoreadalready,youcanskipthissectionandgo
straighttotheexampleofhowwecanactuallyimplementthesesteps.

Basically,ifwehaveaniceandneatequationthatgivesustheslopeofthetangentlinetothepricing
functionordollarduration,thatwouldbenice.Otherwise,theslopeofthetangentlinewouldbesimilar
totheslopeofthebrowndottedlineonthegraphabove.Thisdottedlineconnects2pointsontheblue
curve:thefirstpointiswhenwedecreaseinterestratesbyasmallamountyandthesecondpointis

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

whenweincreaseinterestratesbythesamesmallamounty.Theslopeofthislineissimply

whichistheformulaweuseforthedollarduration.Sinceduration=dollarduration/price,theduration
ofthebondissimply

Importantly,noneofthestepsisparticulartocallablebonds,whichmeans:theprocessisapplicableto
anykindofbondsorinterestratesensitivesecurities.
Toprovideaconcreteexampleofhowtocarryouttheabovesteps,letsconsidercomputingthedollar
durationanddurationofour2yearcallablebond.

Thegoodnewsisstep1isalreadydonebecausewealreadypricethecallablebondinthe
precedingsections.Toremindyouofwhatwedid,Iincludeheretheinterestratetreeweused
aswellastheresultingpricetree.Again,nodespaintedbluearethoseaffectedbythebond
beingcalledattime1.
0

0.5

1.5
16.43%

0.5

12.90%
10.18%
8.08%

95.48639

9.82%

97.33178
9.47%

97.9142
97.807

99.0416

7.53%

99.3003
100

7.27%

1.5
96.1034

94.8869
12.43%

7.80%

100.3528

SoourV0=97.33.

Instep2,weneedtoincreaseinterestratesbyasmallamounty.Letsassumey=10basis
points.Wewilltalkalittlebitaboutthislater,butfornowwewilladd10basispointstoeachof
thenodeoftheinterestratetreeandthenusethetreetopricethecallablebondagain.Again,I
willnotgivethedetailsofthepricingcalculationsbutratherpostheretheresultingpricetree
foryoutocompareyourcalculationsagainst.

0.5

1.5
16.53%

0.5

13.00%
10.28%
8.18%

9.92%

95.35627
97.17068

9.57%
7.63%

1.5
96.0591

94.79989
12.53%

7.90%

97.8682
97.7159

98.9337

99.253
99.9658

7.37%

100.3044

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Asyoucansee,asinterestratesincreaseby10basispoints,bondpricedecreasetoV+=$97.17.
Itturnsoutthatatnowherealongthetreethatitisoptimaltocallthebondgiventhisincrease
ininterestrates.Forthisreason,wedonthaveanybluenodesthistime.

Step3issimilartostep2,exceptthatwenowsubtract10basispointsfromtheoriginalinterest
ratetree.Theresultingratetreeandpricetreeareasfollows:

0.5

1.5
16.33%

0.5

12.80%
10.08%

94.97404
12.33%

7.98%

95.61675

9.72%
7.70%

97.4853
9.37%

97.9604
97.8982

99.1332

7.43%

99.3478
100

7.17%

1.5
96.1479

100.4012

Asinterestratesdecrease,bondpriceincreasestoV=$97.49

GivenV+,V,V0andy=10basispoints,wecancomputethebondsdollardurationanddurationas
follows:

Dollarduration=

Duration=

.
.
.

160.
1.6439.

Thenegativesignsinfrontofdollardurationanddurationarejusttoindicatethatbondpricesand
interestratesmoveinoppositedirections:asinterestratesincrease,bondpricesdecreaseandvice
versa.
(Dollar)Convexity:
ItturnsoutthatitisquitestraightforwardtocomputeconvexityanddollarconvexityonceyouhaveV+,
VandV0allready.Iwillfirstshowyoutheformulastoperformtheneededcalculations.Next,forthose
curious,Ibrieflyandgraphicallyexplaintheideasbehindtheformulas.Again,thispartwillnotbeonthe
test.Therefore,ifyouarenotinterestedinreasoning,youcouldsafelyskipit.

Tocomputedollarconvexity,weusethefollowingformula:

PluggingthevaluesforV+,V,V0intheformula,dollarconvexityofthecallablebondis:
.

.
.

3800.

AdvancedFixedIncome

CallableBonds

ProfessorAnhLe

Tocomputeconvexity,wesimplydividedollarconvexitybytheprice,whichwillgive:
.

39.04.

Asyoucansee,the(dollar)convexityforthecallableisnegative.
Letmenowbrieflyprovidetheintuitionbehindtheformula:

fordollarconvexity.

Asyoualreadyknow,thewholeideaofconvexityadjustmentistocorrectforthedeviationsbetween
thebluecurveanditstangentline.Givenanincreaseofyininterestrates,thedifferencebetweenthe
bluecurveandtheredtangentlineisthedistanceCC1.Givenadecreaseofyininterestrates,the
differencebetweenthebluecurveandtheredtangentlineisthedistanceAA1.Althoughwedontknow
exactlywhatCC1andAA1are,weknowtheiraveragewhichisthedistanceBB1.TheheightofBissimply
theaverageofV+andV.theheightofB1isV0.Therefore,thelengthofBB1issimply:
. Thisexplainswhytheconvexityformula,

Isproportionalto