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Modelling Callable Annuity Bonds with Interest-Only Optionality

Author

Listed:
  • Holst, Anders

    (Nordea, Invettment Management)

  • Nalholm, Morten

    (Department of Finance, Copenhagen Business School)

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.

Suggested Citation

  • Holst, Anders & Nalholm, Morten, 2004. "Modelling Callable Annuity Bonds with Interest-Only Optionality," Working Papers 2004-6, Copenhagen Business School, Department of Finance.
    • Handle: RePEc:hhs:cbsfin:2004_006
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    File URL: http://openarchive.cbs.dk/cbsweb/handle/10398/7149
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    More about this item

    Keywords

    Bonds; I-O optionality;

    JEL classification:

    • G00 - Financial Economics - - General - - - General

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