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Behaviour of bond’s embedded option with regard to credit rating

    Bohumil Stádník Affiliation

Abstract

In this financial engineering research, we study the behaviour of an option premium of a call/put option which is embedded in a typical fixed coupon bond with finite maturity. The contribution of the research is the conclusion about the dynamics of premium changes; represented by direction and sensitivity; with respect to the changes in credit rating and also risk-free interest rate development. The aim of the research is also to clearly demonstrate this theoretically complicated topic to the financial practitioners using a practical example. We are about to consider a 3-dimensional process where the dimensions are: time, rating development process and risk-free interest rate development. We use Standard & Poor’s rating transition matrix to create rating tree and Hull-White model for modelling of risk-free interest rate development. We add embedded call/put option to the bond structure and assume the call/put option to be exercised in case of interest rates decline/rise or rating worsening/improvement. For valuation, we use the risk-neutral concept. Using a numerical solution on the 3-dimensional tree (implemented in MATLAB), we avoid problems that appear while analytical solving of partial differential equations.

Keyword : embedded call/put option, credit rating transition, more dimensional tree, Standard & Poor’s rating, bedded option premium, rating development process

How to Cite
Stádník, B. (2018). Behaviour of bond’s embedded option with regard to credit rating. Business: Theory and Practice, 19, 261-270. https://doi.org/10.3846/btp.2018.26
Published in Issue
Nov 16, 2018
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