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The Handbook of Municipal Bonds by FRANK J. FABOZZI, SYLVAN G. FELDSTEIN

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CHAPTER 28
Valuation of Municipal Bonds with Embedded Options
Frank J. Fabozzi, Ph.D., CFA Professor in the Practice of Finance School of Management, Yale University
 
Andrew Kalotay, Ph.D. President Andrew Kalotay Associates, Inc.
 
Michael P. Dorigan, Ph.D. Senior Quantitative Analyst Municipal Investment Group PNC Capital Advisors
 
 
 
Computing formula-based volatility measures for option-free bonds is straightforward. Applying the same calculations to bonds with embedded options (e.g., callable and putable bonds) is inappropriate. This is because the cash flows on these bonds are uncertain. Instead, the analysis of these bonds must take into account the bonds’ possible cash flow outcomes.
The valuation method that we describe in this chapter allows the investor to identify if a bond is cheap, rich, or fairly priced. Rather than think in terms of price, investors prefer to look at a bond in terms of yield spread. That is, if a valuation model indicates that a municipal bond is cheap by one point, investors seek to translate that amount into a basis point spread relative to the yield of a particular benchmark security. However, as we explain in this chapter, the appropriate benchmark for measuring the yield spread is not a particular point on the municipal yield curve of an issuer, but instead the spread over the theoretical zero-coupon curve of the issuer. This spread, which takes into account the bond’s option features, is referred to as the option-adjusted spread.
The valuation ...

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