Term structure of interest rates and bond valuation: An application to Brady bonds

This thesis presents a general method of estimating the term structure of interest rates and to value the default risk premium of emerging market countries' debt consistent with Brady bond prices and the U.S. term structure of interest rates. The purpose is to obtain an empirical measure of the default risk premium that permits one to perform a relative value analysis among different securities and across countries and to find potential arbitrage opportunities. In addition, the term structure of interest rates of a emerging market country is used to price derivatives and perform price sensitivity analysis of Brady securities. The model of the term structure of interest rates of the emerging market country is based on a binomial tree. This tree represents the random evolution of future short rates, given some inputs and an assumption about the stochastic process for the U.S. short interest rate. The inputs of the model are the yields on zero-coupon and coupon-bearing bonds for various maturities, the yield volatilities for the same bonds, and the current Brady bond prices. Several authors have implemented models that derive the term structure of interest rates from the behavior of the riskless interest rate. While these studies have focused on the riskless term structure of the U.S. Treasury, our tree includes a constant spread value, the default risk premium, which is a spread over the return on Treasury securities. This spread is interpreted as an empirical measure of the default risk premium. Summarizing, the model of the term structure of interest rates implemented in this study is a practical tool to estimate the default risk premium, the option values, and duration and convexity measures for an emerging market country.