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Category: Level II Fixed Income
Valuing Risky Bonds
In this context, a risky bond is one for which there is a nonzero probability of default. Conceptually, valuing such a bond is child’s play: you calculate the (present) value of the bond assuming no default (which the curriculum abbreviates VND: Value, No Default), then subtract the (present) value of the expected credit losses (i.e.,…
Valuing Bonds with Embedded Options
Bonds can be sold with a variety of embedded options, for example: Call options Put options Prepayment options Conversion options In this article, we will concentrate on callable bonds and putable bonds, although we’ll mention prepayable and convertible bonds as well. The common method of valuing a callable or putable bond is to use a…
Valuing Floating-Rate Bonds
Some floating-rate bonds are easy to value: if the coupon resets to the market rate, then the value of the bond will reset to par. (Of course, this assumes that by “the market rate” we mean the rate appropriate for a given bond, which may have to include risk premia above the Treasury rate. If…
Option-Adjusted Spread (OAS)
Option-adjusted spread (OAS) is a yield spread (i.e., an interest rate) that is added to the (1-period forward) interest rate at each node in a binomial tree; specifically, it is the spread that when added to the discount rates results in the tree giving the current market price for a particular bond, after accounting for…
CPR vs. SMM vs. PSA
All of these TLAs (Three-Letter Abbreviations) refer to measurements of the amount of prepayment on a mortgage-backed security (MBS, yet another TLA): CPR abbreviates Conditional Prepayment Rate, an annual measure of the prepayments on an MBS SMM abbreviates Single-Month Mortality, a monthly (duh!) measure of the prepayments on an MBS PSA abbreviates Public Securities Association,…