Impact of Different Interest Rate Models on Bond Value Measures

Abstract

There is an extensive literature on ways of valuing bonds with embedded options and measuring their interest rate risk exposure. Price sensitivity measures-effective duration and effective convexity-are found by shocking rates up and down by the same number of basis points and determining the impact on the value of the security. Yet, despite the critical importance of the measures that are derived from a valuation model-option-adjusted spread, effective duration, and effective convexity-there appears to be no empirical study that examines whether interest rate models produce any significant differences for these measures. The authors examine a callable bond, a putable bond, a callable range note, and a putable range note using several popular interest rate models. The substantial differences in the measures estimated are attributed to characteristics of the interest rate model.