A fundamental approach to corporate bond options

Author:

Simozar Saied1ORCID

Affiliation:

1. Fipmar, Inc. Beverly Hills, CA, USA

Abstract

It is well known that interest rates and credit spreads are negatively correlated. Any successful model for pricing callable corporate bonds has to take this correlation into account. A new approach for the analysis of corporate bond options is developed by using two correlated geometric Brownian motion (GBM) processes for the spread and interest rate components of corporate bond yields. Analysis of the results and comparison with market prices suggest that the traditional methods of calculating the option premium overestimate the value of the call option. Our analysis can also explain why risk neutral credit spreads are significantly wider than implied by default probability and in fact justify higher spreads.

Publisher

World Scientific Pub Co Pte Ltd

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