Valuing Euro Rating-Triggered Step-Up Telecom Bonds

by Patrick Houweling of Rabeco Asset Management,
Albert Mentink of Erasmus University Rotterdam & AEGON Asset Management, and
Ton Vorst of Erasmus University Rotterdam & ABN Amro

January 27, 2004

Abstract: We value rating-triggered step-up bonds with three methods: (i) the Jarrow, Lando and Turnbull [1997, JLT] framework, (ii) a similar framework using historical probabilities and (iii) as plain vanilla bonds. We find that the market seems to value single step-up bonds according to the JLT model, while it values multiple step-up bonds as plain vanilla bonds. Further, step-up feature market premiums are more volatile than JLT and historical premiums, and the JLT model approximates market premiums always better than the historical method. Finally, most step-up bonds offer a cushion against rating migrations via dampened price movements.

JEL Classification: C13, G12, G13.

Keywords: step-up bonds, rating-triggered, credit risk, reduced form models, Jarrow Lando Turnbull.

Published in: Journal of Derivatives, Vol. 11, No. 3, (Spring 2004), pp. 63-80.

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