I am not fundamentally understanding something about KRD’s
What is the relationship between coupons and the moneness of a call.
In specific, can someone please explain this statement:
Callable bonds with options DEEP OUT OF THE MONEY have LOW COUPON RATES and therefore the HIGHEST DURATIONS.
I understand the last part. If it is out the money it behaves more like an option free bond, therefore the maturity of the bond is the KRD. But what about the first part? Why deep out of the money have low coupons?
Just thought it through, is the below reasoning correct?
Low coupon rates mean there is less chance the bond can be recalled and refinanced at a lower rate therefore the option becomes less worthy?
Or as an example, if COUPON WAS HIGH, then you would give back the bond and re finance a newer bond that receives these higher coupons. Therefore the callability increases which reduces the duration due to the negative convexity?
If the market rate is 5% you might consider calling an 8% coupon bond (depending on the call premium), but you wouldn’t consider calling a 2% coupon bond. The former is in the money; the latter is out of the money.
As the bond starts to move in the money, its (effective) duration shortens; you get negative (effective) convexity.
You can view it like this. If the coupons are high then the price of the bond will also be high and there will be less chances that it would be out of money. With low coupon rates, the prices of the bond will be low and the difference between the price and strike price will be high and bond will be more likely have a deep out of money call option.