Callable Bond's Value Analysis Using Binomial Interest Rate Tree Considering Early Redemption and Default Risks

Abstract

Bonds are known as one of low-risk investments and worth to be considered as a part of an investor's portfolio, however there are still underlying risks that could affect its price. This paper focuses on the effect of early redemption risk and default risk to a bond’s value. Using binomial interest rate tree method and its adjusted for default risk version, this paper wants to analyse how these risks affect Indonesian bonds’ values through simulations, while showing how these bonds can be used to construct the binomial interest rate trees. In the default risk simulation, more assumptions are made because of data limitations, which causes the first period recovery fraction to soar higher than the other periods. The analysis shows that, compared to present value of standard bonds, early redemption risk tends to cause the bond's present value to drop, while on the contrary, default risk tends to cause the bond's present value to rise. The cause of higher present value of bonds with default risk is explained by the high first period recovery fraction.

Keywords

• callable bond
• binomial interest rate tree
• early redemption risk
• default risk
• recovery fraction.