A unifying approach for the pricing of debt securities

We propose a unifying framework for the pricing of debt securities under general time-inhomogeneous short-rate diffusion processes. The pricing of bonds, bond options, callable/putable bonds, and convertible bonds (CBs) is covered. Using continuous-time Markov chain (CTMC) approximations, we obtain closed-form matrix expressions to approximate the price of bonds and bond options under general one-dimensional short-rate processes. A simple and efficient algorithm is also developed to price callable/putable debt. The availability of a closed-form expression for the price of zero-coupon bonds allows for the perfect fit of the approximated model to the current market term structure of interest rates, regardless of the complexity of the underlying diffusion process selected. We further consider the pricing of CBs under general bi-dimensional time-inhomogeneous diffusion processes to model equity and short-rate dynamics. Credit risk is also incorporated into the model using the approach of Tsiveriotis and Fernandes (1998). Based on a two-layer CTMC method, an efficient algorithm is developed to approximate the price of convertible bonds. When conversion is only allowed at maturity, a closed-form matrix expression is obtained. Numerical experiments show the accuracy and efficiency of the method across a wide range of model parameters and short-rate models.

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Publication Details

Journal
Quantitative Finance
Published
2024-12-01
DOI
https://doi.org/10.1080/14697688.2024.2423686
Citations
2
Primary Topic
Stochastic processes and financial applications
Type
article
Field-Weighted Citation Impact
1.08

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article

A unifying approach for the pricing of debt securities

Marie-Claude Vachon, Anne MacKay
2 citations
Quantitative Finance
Stochastic processes and financial applications
1.08
article

A unifying approach for the pricing of debt securities

Marie-Claude Vachon, Anne MacKay
article en
2 citations

Abstract

We propose a unifying framework for the pricing of debt securities under general time-inhomogeneous short-rate diffusion processes. The pricing of bonds, bond options, callable/putable bonds, and convertible bonds (CBs) is covered. Using continuous-time Markov chain (CTMC) approximations, we obtain closed-form matrix expressions to approximate the price of bonds and bond options under general one-dimensional short-rate processes. A simple and efficient algorithm is also developed to price callable/putable debt. The availability of a closed-form expression for the price of zero-coupon bonds allows for the perfect fit of the approximated model to the current market term structure of interest rates, regardless of the complexity of the underlying diffusion process selected. We further consider the pricing of CBs under general bi-dimensional time-inhomogeneous diffusion processes to model equity and short-rate dynamics. Credit risk is also incorporated into the model using the approach of Tsiveriotis and Fernandes (1998). Based on a two-layer CTMC method, an efficient algorithm is developed to approximate the price of convertible bonds. When conversion is only allowed at maturity, a closed-form matrix expression is obtained. Numerical experiments show the accuracy and efficiency of the method across a wide range of model parameters and short-rate models.

Quantitative FinanceVol. 24(12)
Université de Sherbrooke (CA), Université du Québec à Montréal (CA)
Université du Québec à Montréal, Natural Sciences and Engineering Research Council of Canada, Fonds de recherche du Québec – Nature et technologies
Partnerships for the goals
Openalex Percentile: Top 25%
Stochastic processes and financial applications
1.08
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