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Pricing Options Embedded in Debentures with Credit Risk

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  • Almeida, Caio
  • Pereira, Leonardo Tavares

Abstract

In this article, we develop a strategy to simultaneously extract a yield curve and price call options embedded in debentures subject to credit risk. The implementation is based on a combination of two methods: term structure estimation adopting the Nelson-Siegel model sequentially followed by the use of the spread-curve (term structure of debentures minus local inter-bank risk-free rate) to calibrate a trinomial tree for short-term interest rates making use of the Hull and White model (1993). The proposed methodology allows us to price embedded options making debentures with and without embedded options comparable on a common basis. As a consequence, since a large number of the existing Brazilian debentures contain embedded options, our methodology increases the number of debentures available to estimate a term structure for Brazilian local fixed income bonds. We illustrate the method by pricing a call option for a debenture issued by the company “Telefonica Brasil”.

Suggested Citation

  • Almeida, Caio & Pereira, Leonardo Tavares, 2016. "Pricing Options Embedded in Debentures with Credit Risk," Brazilian Review of Econometrics, Sociedade Brasileira de Econometria - SBE, vol. 36(1), March.
    • Handle: RePEc:sbe:breart:v:36:y:2016:i:1:a:24027
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