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- An interest rate model is a probabilistic description of how interest rates can change during the life of the bond. An assumption about the relationship between the level of short-term interest rates and the interest rate volatility (measured by the standard deviation), is made to build the interest rate model.
- Binomial model is an option valuation method which is developed based on the assumption that probability of each possible price follows a binomial distribution and that prices can either move to higher level or a lower level with time until the option expires (over any short time period). This model reduces possibilities of price changes, removes the possibility for arbitrage, assumes a perfectly efficient market, and shortens the duration of the option.
- In valuing a callable bond using the binomial model, the cash flows at a node are modified to consider the call option. The value of a call option is derived from deducting the value of an option-free bond the computed value of the callable bond.
- Option-Adjusted Spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded option. It is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options.
- The modified duration is a measure of the sensitivity of a bond's price to interest rate an changes, the assumption made here is that the expected cash flow does not change with the interest rates.
- A convertible bond is a corporate bond with a call option to buy common stock of the issuer. Conversion ratio can be defined as the number of shares a bondholder can receive from a common stock from exercising the call option of the convertible.
- The minimum price of convertible bond is the greater of: (i) its conversion value, or (ii) the value of a corporate bond without the conversion option i.e., the straight value.