A robust pricing of specific structured bonds with coupons

Abstract

Purpose

The purpose of this paper is to present an innovative model to evaluate the fair price of a subset of structured products for a hypothetical US structured bond.

Design/methodology/approach

The authors assume that interest rates dynamics are described by the Cox–Ingersoll–Ross process. They conduct robustness checks by stress testing against parameter and model uncertainty.

Findings

The fair value of the bond is robust under any parameter or model misspecification. In addition, a change in the price seems to be more sensitive to long-term yields rather than short-or mid-term yields. The authors provide a better understanding of the relationship between bond prices and business cycles: a slight change in the current structure would have a significant effect on the bond price only during economic expansions.

Social implications

The recent global financial crisis has led policymakers and the financial press to blame financial innovation through accusations of structured products being highly complex. Much of the criticism is based on the fact that investors were not able to properly price and fully understand the risks of their investments. Regulators should ensure proper pricing of these products to protect both the investors and the system. Fair pricing is important for bond issuers, governments or corporations to design their product at an attractive price for investors.

Originality/value

This paper fills a gap in the extant literature by providing an innovative model based on an Euler–Maruyama Monte Carlo scheme to price structured products.

Citation

Evgenidis, A. and Siriopoulos, C. (2014), "A robust pricing of specific structured bonds with coupons", Journal of Risk Finance, Vol. 15 No. 3, pp. 234-247. https://doi.org/10.1108/JRF-01-2014-0005