Principles of Corporate Finance – A Tale of Value Week 5

HANDOUT 5.4

VALUING RISKY DEBT – AN OVERVIEW

In this Handout 5.4 we provide some very basic comments on the issues that are
instrumental to understand the core ideas behind approaches to valuing fixed-income
instruments. This area is one of the most advanced in finance, and its detailed study goes
way beyond the scope of this Course.
The learners interested in the details of the fixed-income markets and fixed-income valuation
are addressed to the classic book The Handbook of Fixed-Income Securities by F. Fabozzi
(editor) (see Further Reading for Week 5) in which these issues are discussed in quite some
detail and in a reader-friendly way.

MAJOR CHALLENGES TO VALUING RISKY DEBT

In Week 2 we studied the market for riskless bonds. By riskless we mostly meant that the
bonds discussed were not ever expected to default (i.e., the bondholders were positive to
receive the promised coupon and principal payments).
We came up with the following bond valuation formula (we assume that the coupon rate is
constant):

C C C C+F
P= + +... + k
+...
1+ r1 (1+ r2 ) 2
(1+ rk ) (1+ rT )T
▪ Here C – represents the bond’s coupon payments, F – its face (par) value
▪ The key problem is that the interest rates at which we discount the bond cash flows
are different for all k; they are determined by the term structure of interest rates
The more simplified approach to bond valuation is based on the yield to maturity:

C C C F
P= + +... + +
(1+ y) (1+ y) 2 T
(1+ y) (1+ y)T

In bond valuation such an approach is often called a simple “finance” approach. It has a
fundamental drawback:
▪ All bond cash flows are effectively mispriced
Another major challenge of a simplified approach is that it does not account for the options
embedded in risky fixed-income securities. The option-containing securities include:
▪ Callable bonds
▪ Convertible bonds
▪ Putable bonds
▪ Exchangeable bonds
Of special interest (and complexity!) are the prepayment options associated with mortgages
and mortgage-backed securities – for both rational (in case of falling interest rates) and
irrational (the so-called QFDR that stands for “quit,” “fire,” “die,” or “retire”) prepayments.
The existence of embedded options makes the recognition and valuation of these options an
unavoidable part in studying fixed-income securities.

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But that’s much easier said than done due to the following fundamental problems:
▪ First, to assume that the risk-free rate is constant for bonds is absolutely senseless –
the rates change all the time
▪ Thus, the application of the Black–Scholes valuation (that implies that r F = const) is in
most cases out of the question
▪ Unfortunately, that’s not it – we are dealing not only with changing, but with random
interest rates
▪ What makes things even worse – the bond price volatility is random too!
▪ Many embedded bond options are also path-dependent
▪ Further, the transaction costs in fixed-income trading and asset management that are
based on liquidity, are also random
▪ So we face the need to deal with stochastic interest rates and stochastic liquidity
That is all a gigantic mess.

BOND PARAMETERS – DURATION AND CONVEXITY

An important bond parameter is duration – the measure of the bond’s effective maturity.
To find the duration of a bond, we “place” all bond cash flows at one and the same point in
time so that their total PV (discounted from this point at the bond’s yield to maturity) would
be equal to the bond price.
That is achieved by finding the weighted average of PV’s of cash flows where weights are
the times when these cash flows occur divided by the bond’s price P:
𝑇−1 𝑃𝑉(𝐶 ) 𝑃𝑉(𝐹 + 𝐶𝑇 )
𝑖
𝐷= ∑ 𝑖+ 𝑇
𝑖=1 𝑃 𝑃

where (y is the yield to maturity)

𝐶𝑖
𝑃𝑉(𝐶𝑖 ) =
(1 + 𝑦)𝑖

It can be easily seen that the cumbersome formula for the duration can be rewritten as:

𝜕𝑙𝑜𝑔𝑃
𝐷 = −(1 + 𝑦)
𝜕𝑦

or, in the form of small finite changes:

∆𝑃 𝐷
=− ∆𝑦 = −𝐷 ∗ ∆𝑦
𝑃 1+𝑦

Here D is the McCauley duration of the bond, while D* is the modified duration.
The above formulas allow finding D and D* knowing the basic bond’s parameters – coupons,
price, and the yield to maturity. Because bonds pay semiannual coupons, all results will be
in half-years. To find D and D* adjusted for years, we must divide by two.
The bond duration plays an important role in the process of immunization – making the
maturities of assets and liabilities of an investment company not very much different. That
helps reduce the adverse affects of a sharp rise in the interest rates if the assets have long
maturities (recall the S&L problems discussed in our first Course – Capital Markets and
Financial Institutions – How to Survive Them).

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The bond’s price as a function of the yield to maturity is non-linear, so in order to find the
better approximation for the bond’s price we may need to expand the bond’s price into the
series with respect to the changes in yield to maturity y.
The bond’s modified duration is the coefficient in the first term – it is the sensitivity of the
bond’s price changes with respect to the changes in the yield to maturity.
The coefficient in the quadratic term (with respect to the change in y) is called the bond’s
convexity:
1 𝜕2 𝑃
𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 = 𝐶𝑜𝑛𝑣 =
𝑃 𝜕𝑦 2
Then, to the second order of magnitude,

∆𝑃 𝐷 1
=− ∆𝑦 + 𝐶𝑜𝑛𝑣 ∆𝑦 2
𝑃 1+𝑦 2

All results will be in half-years. To find convexity adjusted for years, we divide by four.
Why would people bother about these formulas? Recall that interest rates are random, so
the use of non-linear functions may pose a big problem. In most cases, the second
approximation works fine for not very large changes in y and saves a lot of time, effort,
ingenuity, and computer capacity.

VALUING BONDS WITH EMBEDDED OPTIONS – SOME IDEAS

In this section we provide some ideas applied for valuation of bonds with embedded options.

The Case of a Callable Bond

The call option is valuable for the issuer. If we take the view of an investor,
𝐶𝐵 = 𝑁𝐶𝐵 − 𝑂
where CB is a callable bond, NCB is a non-callable bond (with the same maturity and
coupons), and O is the call option. Then, clearly,
𝑃𝐶𝐵 = 𝑃𝑁𝐶𝐵 − 𝑃𝑂

In order to determine the duration and convexity of the callable bond, we can express them
in terms of the corresponding parameters and prices of the non-callable bond (for which we
know how to do it) and the parameters of the call option as follows:

𝑃𝑁𝐶𝐵
𝐷𝐶𝐵 = (1 − ∆) 𝐷𝑁𝐶𝐵
𝑃𝐶𝐵

𝑃𝑁𝐶𝐵 2
𝐶𝑜𝑛𝑣𝐶𝐵 = {𝐶𝑜𝑛𝑣𝑁𝐶𝐵 (1 − ∆) − 𝑃𝑁𝐶𝐵 Γ 𝐷𝑁𝐶𝐵 }
𝑃𝐶𝐵

where ∆ and Γ are the parameters of the call option.

The value of the call option is normally determined with the use of binomial methods by way
of computer modeling. Then it becomes feasible to “adjust” the parameters of the
non-callable bond and obtain the following parameters of the callable bonds:
▪ The option-adjusted yield (OAY)
▪ The option-adjusted spread (OAS)

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▪ The option-adjusted duration (OAD)

▪ The option-adjusted convexity (OAC)

A Few Words About Mortgages and CMO’s

The most challenging thing in valuing mortgages and mortgage-backed securities is finding
the value of the prepayment option.
As has been discussed earlier in this Handout 5.4, there are both rational (in case of falling
interest rates) and irrational (the so-called QFDR that stands for “quit,” “fire,” “die,” or “retire”)
prepayments.
As a results, mortgages become super risky instruments due to the embedded prepayment
options. Clearly, the mortgage-backed derivatives are even riskier.
To approach the CMO valuation people engage in a two-step procedure:
▪ First, they study the cash flows of the underlying mortgages and value the
corresponding prepayment options
▪ Then they follow through the procedures by which the mortgage cash flows get
redistributed to the holders of the CMO tranches
Again, all that is much easier said than done. But the understanding of the ideas helps to
correctly apply the computer models and draw the corresponding conclusions.
The more detailed discussion and examples can be found in The Handbook of Fixed-Income
Securities by F. Fabozzi (editor) (see Further Reading for Week 5).

FURTHER READING FOR WEEK 5

1. BMA, Chapter 20 – Understanding Options.

2. BMA, Chapter 21 – Valuing Options.
3. BMA, Chapter 22 – Real Options.
4. F. Black, “How We Came up with the Option Formula,” Journal of Portfolio Management
15 (1989), pp. 4–8.
5. F. Black, “The Holes in Black–Scholes,” RISK Magazine 1 (1988), pp. 27–29.
6. F. Black, “How to use the Holes in Black–Scholes,” Journal of Applied Corporate
Finance 1 (Winter 1989), pp. 67–73.
7. J. Hull. Options, Futures and Other Derivatives, 7th ed., Englewood Cliffs, Prentice-Hall,
Inc., 2008.

8. F. J. Fabozzi (ed.) The Handbook of Fixed Income Securities, 6th ed., McGraw-Hill,
2005.

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