The Methodology in Practice

FIGURE 12.2 Impact of a Call Option on the Price/Yield Profile of a Corporate Bond  

We conclude this chapter with an illustration of the OAS technique. Consider a five-year semiannual corporate bond with a coupon of 8 percent. The bond incorporates a call feature that allows the issuer to call it after two years and is currently priced at 104.25. This is equivalent to a yield-to-maturity of 6.979 percent. We wish to measure the value of the call feature to the issuer, and we can do this using the OAS technique. Assume that a five-year Treasury security also exists with a coupon of 8 percent and is priced at 109.11, a yield of 5.797 percent. The higher yield reflects the market-required premium due to the corporate bond s default risk and call feature. 

PERIOD YTM DATE SPDT RATE DISCDUNT EACTDR CASH ELDW PRESENT VALUE DAS ADJUSTED SPDT RATE PV DE DAS-ADJUSTED CASH ELDWS 

The term embedded is used because the option element of the bond cannot be stripped out and traded separately, for example, the call option inherent in a callable bond. 

The term structure of interest rates is the spot rate yield curve spot rates are viewed as identical to zero-coupon bond interest rates where there is a market of liquid zero-coupon bonds along regular maturity points. As such a market does not exist anywhere the spot rate yield curve is considered a theoretical construct, which is most closely equated by the zero-coupon term structure derived from the prices of default-free liquid government bonds. 

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