The pricing and optimal strategies of callable warrants

In this paper, we introduce a valuation model of callable warrants under a setting of the optimal stopping problem between the holder (investor) and the issuer (firm). A warrant is the right to purchase new shares at a predetermined price. When the new stocks are issued, the value of the stock is diluted. We consider the model taking the dilution into account. After identifying optimal policies for the issuer and the investor, we explore the analytical properties of the optimal exercise and call boundaries for the holder and the issuer, respectively. Furthermore, the value of such a callable warrant and the optimal critical prices are examined numerically using the binomial method.     

Game Options Analysis of the Information Role of Call Policies in Convertible Bonds

Abstract

In debt financing, existence of information asymmetry on the firm quality between the firm management and bond investors may lead to significant adverse selection costs. We develop the two-stage sequential dynamic two-person game option models to analyse the market signalling role of the callable feature in convertible bonds. We show that firms with positive private information on earning potential may signal their type to investors via the callable feature in a convertible bond. We present the variational inequalities formulation with respect to various equilibrium strategies in the two-person game option models via characterization of the optimal stopping rules adopted by the bond issuer and bondholders. The bondholders’ belief system on the firm quality may be revealed with the passage of time when the issuer follows his optimal strategy of declaring call or bankruptcy. Under separating equilibrium, the quality status of the firm is revealed so the information asymmetry game becomes a new game under complete information. To analyse pooling equilibrium, the corresponding incentive compatibility constraint is derived. We manage to deduce the sufficient conditions for the existence of signalling equilibrium of our game option model under information asymmetry. We analyse how the callable feature may lower the adverse selection costs in convertible bond financing. We show how a low-quality firm may benefit from information asymmetry and vice versa, underpricing of the value of debt issued by a high-quality firm.     

Arbitrage valuation and bounds for sinking-fund bonds with multiple sinking-fund dates

The paper tackles the problem of pricing, under interest-rate risk, a default-free sinking-fund bond which allows its issuer to recurrently retire part of the issue by (a) a lottery call at par, or (b) an open market repurchase. By directly modelling zero-coupon bonds as diffusions driven by a single-dimensional Brownian motion, a pricing formula is supplied for the sinking-fund bond based on a backward induction procedure which exploits, at each step, the martingale approach to the valuation of contingent-claims. With more than one sinking-fund date, however, the pricing formula is not in closed form, not even for simple parametrizations of the process for zerocoupon bonds, so that a numerical approach is needed. Since the computational complexity increases exponentially with the number of sinking-fund dates, arbitrage-based lower and upper bounds are provided for the sinking-fund bond price. The computation of these bounds is almost effortless when zero-coupon bonds are as described by Cox, Ingersoll and Ross. Numerical comparisons between the price of the sinking-fund bond obtained via Monte Carlo simulation and these lower and upper bounds are illustrated for different choices of parameters.     

American Call Options Under Jump‐Diffusion Processes – A Fourier Transform Approach

We consider the American option pricing problem in the case where the underlying asset follows a jump‐diffusion process. We apply the method of Jamshidian to transform the problem of solving a homogeneous integro‐partial differential equation (IPDE) on a region restricted by the early exercise (free) boundary to that of solving an inhomogeneous IPDE on an unrestricted region. We apply the Fourier transform technique to this inhomogeneous IPDE in the case of a call option on a dividend paying underlying to obtain the solution in the form of a pair of linked integral equations for the free boundary and the option price. We also derive new results concerning the limit for the free boundary at expiry. Finally, we present a numerical algorithm for the solution of the linked integral equation system for the American call price, its delta and the early exercise boundary. We use the numerical results to quantify the impact of jumps on American call prices and the early exercise boundary.     

Monte Carlo analysis of convertible bonds with reset clauses

This paper analyzes some features of non-callable convertible bonds with reset clauses via both analytic and Monte Carlo simulation approaches. Assume that the underlying stock receives no dividends and that it has credit risk of the issuer. We mean by reset that the conversion price is adjusted downwards if the underlying stock price does not exceed pre-specified prices. Reset convertibles are usually issued when the outlook for the issuer is unfavorable. The price of any convertible bonds can be approximately viewed as a sum of values of an otherwise identical non-convertible bond plus an embedded option to convert the bond into the underlying stock. In this paper, we first develop an exact formula for the conversion option value of the European riskless convertible in the classical Black–Scholes–Merton framework. It is shown by Monte Carlo simulation that conversion option value estimates of the American risky convertible are located in a certain region defined by this formula. From estimates of the conversion probability, it is also shown that there exists an optimal reset time in the latter half of the trading interval.     

Valuation of sinking-fund bonds in the Vasicek and CIR frameworks∗Financial support from Murst Fondo 40% on ‘Modelli di struttura a termine dei tassi d'interesse’ is gratefully acknowledged.

In a sinking-fund bond, the issuer is required to retire portions of the bond prior to maturity, with the option of doing so either by calling the bonds by lottery, or by buying them back at their market value. This paper discusses the valuation of a default-free sinking-fund bond issue in the Vasicek (1977) and, alternatively, the Cox, Ingersoll and Ross (CIR) (1985) frameworks. We show in particular that, calling the bond issue without the delivery option ‘corresponding serial’, and the one without the prepayment feature ‘corresponding coupon’, under no-arbitrage a sinking-fund bond can be priced either in terms of the corresponding coupon bond and a bond call option, or in terms of the corresponding serial and a bond put option. We also present a detailed comparative-statics analysis of our valuation model, where we show that a sinking-fund bond has a stochastic duration intermediate between the ones of the corresponding serial and coupon bonds. We argue that such a feature gives a further rational for the presence of the delivery option. Moreover, we compare our results with the ones of Ho (1985), who has previously discussed the valuation problem under scrutiny.     

Pricing American currency options in an exponential Lévy model

In this article the problem of the American option valuation in a Lévy process setting is analysed. The perpetual case is first considered. Without possible discontinuities (i.e. with negative jumps in the call case), known results concerning the currency option value as well as the exercise boundary are obtained with a martingale approach. With possible discontinuities of the underlying process at the exercise boundary (i.e. with positive jumps in the call case), original results are derived by relying on first passage time and overshoot associated with a Lévy process. For finite life American currency calls, the formula derived by Bates or Zhang, in the context of a negative jump size, is tested. It is basically an extension of the one developed by Mac Millan and extended by Barone‐Adesi and Whaley. It is shown that Bates' model generates pretty good results only when the process is continuous at the exercise boundary.     

Sequential Arbitrage Measurements and Interest Rate Envelopes

This paper proposes new measures that provide us with the level of sequential arbitrage in bond markets. All the measures vanish in an arbitrage-free market and all of them are positive otherwise. Each measure is generated by a dual pair of optimization problems. Primal problems permit us to compute optimal sequential arbitrage strategies, if available. Each dual problem generates a concrete proxy for the term structure of interest rates. The set of proxies allows us to obtain the exact market price of any bond and may measure several effects. For instance, the credit risk spread of nondefault free bonds, or the embedded option price of callable or extendible bonds. The developed theory has been tested empirically.     

On modified Mellin transforms, Gauss-Laguerre quadrature, and the valuation of American call options

We extend a framework based on Mellin transforms and show how to modify the approach to value American call options on dividend-paying stocks. We present a new integral equation to determine the price of an American call option and its free boundary using modified Mellin transforms. We also show how to derive the pricing formula for perpetual American call options using the new framework. A result due to Kim (1990) [24] regarding the optimal exercise price at expiry is also recovered. Finally, we apply Gauss-Laguerre quadrature for the purpose of an efficient and accurate numerical valuation.     

Analysis of arbitrarily shaped planar cracks in two-dimensional hexagonal quasicrystals with thermal effects. Part II: Numerical solutions

The extended displacement discontinuity (EDD) boundary element method is developed to analyze an arbitrarily shaped planar crack in two-dimensional (2D) hexagonal quasicrystals (QCs) with thermal effects. The EDDs include the phonon and phason displacement discontinuities and the temperature discontinuity on the crack face. Green's functions for uniformly distributed EDDs over triangular and rectangular elements for 2D hexagonal QCs are derived. Employing the proposed EDD boundary element method, a rectangular crack is analyzed to verify the Green's functions by discretizing the crack with rectangular and triangular elements. Furthermore, the elliptical crack problem for 2D hexagonal QCs is investigated. Normal, tangential, and thermal loads are applied on the crack face, and the numerical results are presented graphically.     

Market implied volatilities for defaultable bonds

Typically, implied volatilities for defaultable instruments are not available in the financial market since quotations related to options on defaultable bonds or on credit default swaps are usually not quoted by brokers. However, an estimate of their volatilities is needed for pricing purposes. In this paper, we provide a methodology to infer market implied volatilities for defaultable bonds using equity implied volatilities and CDS spreads quoted by the market in relation to a specific issuer. The theoretical framework we propose is based on the Merton’s model under stochastic interest rates where the short rate is assumed to follow the Hull–White model. A numerical analysis is provided to illustrate the calibration process to be performed starting from financial market data. The market implied volatility calibrated according to the proposed methodology could be used to evaluate options where the underlying is a risky bond, i.e. callable bond or other types of credit-risk sensitive financial instruments.

     

Free boundary problem concerning pricing convertible bond

In this paper, we consider some behaviors of the optimal conversion boundaries (i.e. free boundaries) of American‐style convertible bond with finite horizon in some case. The bond's holder may convert it into the stock of its issued firm at any time before maturity, and the firm may call it at any time before maturity. Its pricing model is a parabolic variational inequality, in which the fundamental variables are time and the stock price of the bond's issuer. We achieve some properties of the free boundary, besides the existence and uniqueness of the solution of the variational inequality, such as: the monotonicity, the boundedness, smoothness and its starting point. Moreover, we analyze the relationship between the free boundary and the parameters in the problem, as well as, obtain the critical condition where the free boundary is a constant independent of time. Copyright © 2011 John Wiley & Sons, Ltd.     

Electricity swing options: Behavioral models and pricing

Electricity swing options are supply contracts for power, which give the owner the right to change the required delivery on short time notice. It gives more flexibility than fixed base load or peak load contracts. The name “option” is a bit misleading, since it gives the owner multiple exercise rights at many different time horizons with exercise amounts on a continuous scale. We look at the problem to determine a rational ask price for such a contract from the viewpoint of the contract seller. The pricing of these contracts differs drastically from the pricing of financial options. First, peculiar properties arise from the non-storability of the underlying (the energy) and therefore the impossibility to hedge with the underlying, hedging is only possible with some future contracts. Second, the behavior of the owner plays an important role. Based on some behavioral model for the option holder, we develop a game-theoretic model, which allows to identify the equilibrium price. Besides some theoretical results, we present some numerical results which clarify the dependence of the asked price on the amount of flexibility offered in the swing option.     

Incorporating boundary conditions in a stochastic volatility model for the numerical approximation of bond prices

In this paper, we consider a two-factor interest rate model with stochastic volatility, and we assume that the instantaneous interest rate follows a jump-diffusion process. In this kind of problems, a two-dimensional partial integro-differential equation is derived for the values of zero-coupon bonds. To apply standard numerical methods to this equation, it is customary to consider a bounded domain and incorporate suitable boundary conditions. However, for these two-dimensional interest rate models, there are not well-known boundary conditions, in general. Here, in order to approximate bond prices, we propose new boundary conditions, which maintain the discount function property of the zero-coupon bond price. Then, we illustrate the numerical approximation of the corresponding boundary value problem by means of an alternative direction implicit method, which has been already applied for pricing options. We test these boundary conditions with several interest rate pricing models.     

Pricing Parisian down-and-in options

In this paper, we price American-style Parisian down-and-in call options under the Black–Scholes framework. Usually, pricing an American-style option is much more difficult than pricing its European-style counterpart because of the appearance of the optimal exercise boundary in the former. Fortunately, the optimal exercise boundary associated with an American-style Parisian knock-in option only appears implicitly in its pricing partial differential equation (PDE) systems, instead of explicitly as in the case of an American-style Parisian knock-out option. We also recognize that the “moving window” technique developed by Zhu and Chen (2013) for pricing European-style Parisian up-and-out call options can be adopted to price American-style Parisian knock-in options as well. In particular, we obtain a simple analytical solution for American-style Parisian down-and-in call options and our new formula is written in terms of four double integrals, which can be easily computed numerically.     

Regularity of the American Put option in the Black–Scholes model with general discrete dividends

We analyze the regularity of the value function and of the optimal exercise boundary of the American Put option when the underlying asset pays a discrete dividend at known times during the lifetime of the option. The ex-dividend asset price process is assumed to follow the Black–Scholes dynamics and the dividend amount is a deterministic function of the ex-dividend asset price just before the dividend date. This function is assumed to be non-negative, non-decreasing and with growth rate not greater than 1. We prove that the exercise boundary is continuous and that the smooth contact property holds for the value function at any time but the dividend dates. We thus extend and generalize the results obtained in Jourdain and Vellekoop (2011) [10] when the dividend function is also positive and concave. Lastly, we give conditions on the dividend function ensuring that the exercise boundary is locally monotonic in a neighborhood of the corresponding dividend date.     

企业债券的欧式期权的定价公式

本文研究了带有信用风险的企业债券的欧式衍生资产的定价方法,建立风险债券与无风险债券期权价格的相互关系。     

Robust optimization models for managing callable bond portfolios

A major sector of the bond markets is currently represented by instruments with embedded call options. The complexity of bonds with call features, coupled with the recent increase in volatility, has raised the risks as well as the potential rewards for bond holders. These complexities, however, make it difficult for the portfolio manager to evaluate individual securities and their associated risks in order to successfully construct bond portfolios. Traditional bond portfolio management methods are inadequate, particularly when interest-rate-dependent cashflows are involved. In this paper we integrate traditional simulation models for bond pricing with recent developments in robust optimization to develop tools for the management of portfolios of callable bonds. Two models are developed: a single-period model that imposes robustness by penalizing downside tracking error, and a multi-stage stochastic program with recourse. Both models are applied to create a portfolio to track a callable bond index. The models are backtested using ex poste market data over the period from January 1992 to March 1993, and they perform constistently well.     

随机利率下奇异期权的定价公式

在随机利率条件下,借助于测度变换获得了复合看涨期权的一般的定价公式,同时利用鞅理论和Girsanov定理,在利率服从于扩展的Vasicek利率模型时,得到了复合看涨期权精确的定价公式.用同样的方法,考虑了预设日期的重置看涨期权的定价问题,在利率服从同样的利率模型时,获得了重置看涨期权的定价公式.数值化的结果进一步说明了当利率遵循扩展的Vasicek利率模型时,B-S看涨期权的价格关于标的资产的价格是严格单调递增的,复合看涨期权的Geske公式是可以推广到随机利率的情况.     

Green's functions for forced vibration analysis of bending-torsion coupled Timoshenko beam

A method based on Green's functions is proposed for the analysis of the steady-state dynamic response of bending-torsion coupled Timoshenko beam subjected to distributed and/or concentrated loadings. Damping effects on the bending and torsional directions are taken into account in the vibration equations. The elastic boundary conditions with bending-torsion coupling and damping effects are derived and the classical boundary conditions can be obtained by setting the values of specific stiffness parameters of the artificial springs. The Laplace transform technology is employed to work out the Green's functions for the beam with arbitrary boundary conditions. The Green's functions are obtained for the beam subject to external lateral force and external torque, respectively. Coupling effects between bending and torsional vibrations of the beam can be studied conveniently through these analytical Green's functions. The direct expressions of the steady-state responses with various loadings are obtained by using the superposition principle. The present Green's functions for the Timoshenko beam can be reduced to those for Euler–Bernoulli beam by setting the values of shear rigidity and rotational inertia. In order to demonstrate the validity of the Green's functions proposed, results obtained for special cases are given for a comparison with those given in the literature and they agree with each other exactly. The influences of external loading frequency and eccentricity on Green's functions of bending-torsion coupled Timoshenko beam are investigated in terms of the numerical results for both simply supported and cantilever beams. Moreover, the symmetric property of the Green's functions and the damping effects on the amplitude of Green's functions of the beam are discussed particularly.