Modelling Callable Annuity Bonds with Interest-Only Optionality

Anders Holst, Morten Nalholm

Research output: Working paperResearch

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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.
Original languageEnglish
Place of PublicationFrederiksberg
PublisherInstitut for Finansiering, Copenhagen Business School
Number of pages47
ISBN (Print)8790705823
Publication statusPublished - 2004
SeriesWorking Papers / Department of Finance. Copenhagen Business School
Number2004-6
ISSN0903-0352

Cite this

Holst, A., & Nalholm, M. (2004). Modelling Callable Annuity Bonds with Interest-Only Optionality. Frederiksberg: Institut for Finansiering, Copenhagen Business School. Working Papers / Department of Finance. Copenhagen Business School, No. 2004-6
Holst, Anders ; Nalholm, Morten . / Modelling Callable Annuity Bonds with Interest-Only Optionality. Frederiksberg : Institut for Finansiering, Copenhagen Business School, 2004. (Working Papers / Department of Finance. Copenhagen Business School; No. 2004-6).
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Holst, A & Nalholm, M 2004 'Modelling Callable Annuity Bonds with Interest-Only Optionality' Institut for Finansiering, Copenhagen Business School, Frederiksberg.

Modelling Callable Annuity Bonds with Interest-Only Optionality. / Holst, Anders; Nalholm, Morten .

Frederiksberg : Institut for Finansiering, Copenhagen Business School, 2004.

Research output: Working paperResearch

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AB - 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.

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Holst A, Nalholm M. Modelling Callable Annuity Bonds with Interest-Only Optionality. Frederiksberg: Institut for Finansiering, Copenhagen Business School. 2004.