Reset bonds do not require the issuer to repurchase and reissue the bonds, only to reset the interest rate. Reset bonds typically reset on a specific date, but may also do so if a certain event occurs, such as a downgrade of the company's bonds by a credit-rating agency. Suppose A-OK Corp.
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If A-OK Corp. Municipal reset bonds operate a little differently. These bonds typically have interest rates that periodically reset at multiples of seven days. Other municipal reset bonds reset daily. Despite the frequent resets, municipal reset bonds often have longer maturities of five to 30 years.
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Generally, municipal resets are sold via auction, which determines the rate. The auction rate remains until the next reset date. Although resetting coupons on specific dates or in the event specific events occur protects bondholders, resetting can cause financial difficulties for the issuer.
When a coupon is reset -- most commonly, increased -- it increases the amount of cash the issuer must pay out to bondholders. It seems that one would need to estimate the evolution of the forward rates in time.
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No book talks about that. They just assume that the forward rates will be realized; post a ficticious payment at the end; make them look like bonds; find discount rate that matches the value of both the legs. No simulation. I must be missing something here. I will appreciate an explanation. The reason why you can price a swap without a model is because you can replicate the payoff using only zero-coupon bonds.
Note that I assumed the discount curve is the Libor curve.
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Things are actually a bit more complicated in a multicurve framework. The currently existing interest rate curve expressed for example in terms of the present value of 1 USD paid at various future dates, or equivalently as a list of forward rates for all future periods is sufficient to price swaps by arbitrage.
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That is why no model, no simulation of future interest rates is necessary to value a swap OTOH interest rate options like a caplet are a different kettle of fish. Question is why we are considering the immediately next coupon payment date for valuation of floating rate..
Add to that the coupon payment on the next payment date essentially gives you the value of the floating leg as on the next reset date. Discount it today's date to give the value of the floating leg as of today. The Stack Overflow podcast is back!
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