Ch5 The Science of Term Structure Models

1. Rate and Price Trees
1-1. video clips:
one step for option price: http://www.youtube.com/watch?v=kml52n2zmQs&feature=PlayList&p=1F93169FC44F4F23&playnext=1&playnext_from=PL&index=35
two step binomial: http://www.youtube.com/watch?v=YJls_RgTniw&feature=related

1-2. Binomial Model: A model that assumes that interest rates can take only one of two possible values in the next period
- interest rate tree: set of possible interest paths

2. Risk-Neutral Pricing
*interest rate drift: difference between the risk-neutral and true probabilities

3. Fixed-Income Securities & Black-Sholes-Merton Model
3-1. BSM Model: equity option-pricing model
**Assumptions
i. no upper limit to the price of the underlying asset
ii. constant risk-free rate <--> bond: shor-term rates
iii. constant price volatility <--> price volatility decreases as the bond approaches maturity

4. Callable Bonds
A call option gives the issuer the right to buy back the bond at fixed prices at one or more points in the future, prior to the date of maturity.
- negative convexity as interest rates fall
- callability effectively caps the investor's capital gains as yields fall
- increased reinvestiment risk when yields fall
- less price volatility

5. Putable Bonds
The put feature give the bondholder the right to sell the bond back to the issure at a set price.
The put price serves as a floor value for the price of the bond