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A robust pricing of specific structured bonds with coupons

A robust pricing of specific structured bonds with coupons Purpose – The purpose of this paper is to present an innovative model to evaluate the fair price of a subset of structured products for a hypothetical US structured bond. Design/methodology/approach – The authors assume that interest rates dynamics are described by the Cox–Ingersoll–Ross process. They conduct robustness checks by stress testing against parameter and model uncertainty. Findings – The fair value of the bond is robust under any parameter or model misspecification. In addition, a change in the price seems to be more sensitive to long‐term yields rather than short‐or mid‐term yields. The authors provide a better understanding of the relationship between bond prices and business cycles: a slight change in the current structure would have a significant effect on the bond price only during economic expansions. Social implications – The recent global financial crisis has led policymakers and the financial press to blame financial innovation through accusations of structured products being highly complex. Much of the criticism is based on the fact that investors were not able to properly price and fully understand the risks of their investments. Regulators should ensure proper pricing of these products to protect both the investors and the system. Fair pricing is important for bond issuers, governments or corporations to design their product at an attractive price for investors. Originality/value – This paper fills a gap in the extant literature by providing an innovative model based on an Euler–Maruyama Monte Carlo scheme to price structured products. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Risk Finance Emerald Publishing

A robust pricing of specific structured bonds with coupons

The Journal of Risk Finance , Volume 15 (3): 14 – May 19, 2014

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References (34)

Publisher
Emerald Publishing
Copyright
Copyright © 2014 Emerald Group Publishing Limited. All rights reserved.
ISSN
1526-5943
DOI
10.1108/JRF-01-2014-0005
Publisher site
See Article on Publisher Site

Abstract

Purpose – The purpose of this paper is to present an innovative model to evaluate the fair price of a subset of structured products for a hypothetical US structured bond. Design/methodology/approach – The authors assume that interest rates dynamics are described by the Cox–Ingersoll–Ross process. They conduct robustness checks by stress testing against parameter and model uncertainty. Findings – The fair value of the bond is robust under any parameter or model misspecification. In addition, a change in the price seems to be more sensitive to long‐term yields rather than short‐or mid‐term yields. The authors provide a better understanding of the relationship between bond prices and business cycles: a slight change in the current structure would have a significant effect on the bond price only during economic expansions. Social implications – The recent global financial crisis has led policymakers and the financial press to blame financial innovation through accusations of structured products being highly complex. Much of the criticism is based on the fact that investors were not able to properly price and fully understand the risks of their investments. Regulators should ensure proper pricing of these products to protect both the investors and the system. Fair pricing is important for bond issuers, governments or corporations to design their product at an attractive price for investors. Originality/value – This paper fills a gap in the extant literature by providing an innovative model based on an Euler–Maruyama Monte Carlo scheme to price structured products.

Journal

The Journal of Risk FinanceEmerald Publishing

Published: May 19, 2014

Keywords: Bond pricing; CIR model; Euler–Maruyama Monte Carlo; Structured bonds; classification: G12, G17, G2

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