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Pricing debt instruments: the options approach

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Disciplines
  • Design
  • Economics

Abstract

ECONOMIC REVIEW Federal Reserve Bank of San Francisco Summer 1983 Number 3 Randall J. Pozdena and Ben Iben* As interest rates have become more volatile, par- ticipants in financial markets have become more aware of the need to accommodate interest rate uncertainty in the design of their portfolios. This increased awareness has led to a rise in the demand for mechanisms capable of transferring interest rate risk between the parties to a transaction. One of these mechanisms is the trading of options on debt securities such as Treasury bills and Trea- sury notes. These instruments, traded on organized exchanges, give the holder the option to buy or sell a debt security at a predetennined price within a specific time frame. As such, they help a market participant avoid the effect of interest rate risk on the value of his portfolio. However, the investor in debt options must be able to determine whether the option is "over-" or "underpriced" from his stand- point compared to the price determined by the market. A similar observation may be made concerning the pricing of liability products by depository insti- tutions. Fixed rate bank or savings and loan time deposits, for example, traditionally offer a fixed return over the term with significant penalties for premature liquidation. In a period of volatile inter- est rates, the choice of the combination of the de- posit rate and the early withdrawal penalty can critically affect the marketability of the fixed rate deposit instrument in comparison to a more nearly variable rate instrument such as money market mutual fund shares. Thus, financial institutions, like investors in debt securities, also face the difficulty of determining the appropriate price of an option-in their case, the early withdrawal option inherent in their fixed rate deposits. There is certainly some "price" at which *Senior Economist and Research Associate, Fed- eral Reserve Bank of San Francisco. Our thanks to Lloyd Dixon for research assistance early in this projec

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