Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Finance

No 2004-6: Modelling Callable Annuity Bonds with Interest-Only Optionality

Anders Holst and Morten Nalholm
Additional contact information
Anders Holst: Nordea, Invettment Management, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
Morten Nalholm: Department of Finance, Copenhagen Business School, Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark

Abstract: In this paper an investigation of the pricing of callable annuities with interest-only (I-O) optionality is conducted. First the I-O optionality feature of callable annuities is introduced. Next an algorithm for pricing callable annuities with I-O optionality using the finite difference methodology, is formulated. This is then used to investigate optimal strategies of I-O bonds and impacts on prices from the I-O optionality. It is found that the I-O feature necessitates a simultaneous valuation of all elements of the callable I-O bond. Following this, the Greeks of the I-O bond are investigated. It is found that they are affected by the I-O feature, but only to a limited extent. Finally, a model of heterogenous prepayment decisions is incorporated into the framework. The model is extended to model heterogeneity in the I-O exercise decisions. The incorporation of heterogeneity in borrower decisions is found to lead to reasonable causalities.

Keywords: Bonds; I-O optionality

JEL-codes: G00

47 pages, June 1, 2004

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