Risk Management for Bonds with Embedded Options

Antonio Díaz and Marta Tolentino
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Antonio Díaz: Department of Economics and Finance, University of Castilla-La Mancha, 02071 Albacete, Spain
Marta Tolentino: Department of Economics and Finance, University of Castilla-La Mancha, 13003 Ciudad Real, Spain

Mathematics, 2020, vol. 8, issue 5, 1-12

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.

Keywords: bonds with embedded options; nonarbitrage interest rates models; effective duration; effective convexity (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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