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Heterogeneous-Expectations Model of the Value of Bonds Bearing Call Options

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  • Zvi Bodie
  • Benjamin M. Friedman

Abstract

This paper develops a dynamic programming model of the optimal refunding strategy and the corresponding value of a callable bond. The model differs from previous work on this subject primarily in that it explicitly admits the possibility of differences between the issuer's expectations of future interest rates and an investor's corresponding expectations. This generalization facilitates the application of the model to determine what a specific bond (issued, for example, by a particular corporation) is worth to any given investor. Additional analytical features of the model, which differ from corresponding aspects of some previous models, include the use of a stochastic discounting rate and the use of continuous distributions to characterize the relevant interest rate expectations. For the bond issuer, his own expectations (together with the bond's coupon and call features) suffice to indicate the critical refunding yield as well as the expected value of the bond in each time period until the bond matures. For an investor, however, the analytical solution of the model and the illustrative numerical examples presented in the paper show that the issuer's expectations and the investor's own both matter if the two differ.

Suggested Citation

  • Zvi Bodie & Benjamin M. Friedman, 1977. "Heterogeneous-Expectations Model of the Value of Bonds Bearing Call Options," NBER Working Papers 0218, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0218
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    References listed on IDEAS

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    1. F. A. Lutz, 1940. "The Structure of Interest Rates," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 55(1), pages 36-63.
    2. Ofer, Aharon R & Taggart, Robert A, Jr, 1977. "Bond Refunding: A Clarifying Analysis," Journal of Finance, American Finance Association, vol. 32(1), pages 21-30, March.
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    8. Bodie, Zvi & Friedman, Benjamin M, 1978. "Interest Rate Uncertainty and the Value of Bond Call Protection," Journal of Political Economy, University of Chicago Press, vol. 86(1), pages 19-43, February.
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    1. Bodie, Zvi & Friedman, Benjamin M, 1978. "Interest Rate Uncertainty and the Value of Bond Call Protection," Journal of Political Economy, University of Chicago Press, vol. 86(1), pages 19-43, February.

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