CFAI Sample Question

Jokinen expects that the current environment of low interest rates and low interest rate volatility may not continue. So, he analyzes the effects of an increase in interest rates and volatility on the value of any callable bonds in the portfolio. Jokinen states: • “If interest rates rise and interest rate volatility remains unchanged, the value of callable bonds should decrease.” • “If interest rate volatility increases and interest rates remain unchanged, the value of the callable bonds should increase.” Are Jokinen’s statements regarding the effects on callable bonds of an increase in interest rates and an increase in interest rate volatility, respectively, correct? …Interest rates…Interest rate volatility A…No…No B…No…Yes C…Yes…No D…Yes…Yes

Interest rates: As rates goes up, the value of the bond goes down. Statement Incorrect Interest rate volatility: More volatility give more value to the option. The bond holder is short the call option. The value of the callable bond should decrease. Statement Incorrect Answer: A)

I’m thinking C.

if rates go up, value of the bond goes down. again from the perspective of the bondholder, if vol picks up, option value goes up (the issuer is long the call option, not the bondholder) so the value of the callable bond goes down… i think olivier said the same thing and choose the wrong answer?

I would go with C as well for the reasons given above. I havent really been doing the CFAI questions. Do the they have a/b/c/d questions in the books as well? Just remember seeing open ended questions. Or is this a question from the online sample exams?

C seems correct to me as well.

C, for the reasons above. To clarify on the first statement. When rates go up, the value of the call option does decrease, however, the devaluation of the bond will more than offset the impact of the reduced value of the imbedded option, causing the overall value to decrease.

C is correct. A rise in interest rates will reduce the value of the bond. Jokinen’s first statement is correct. If volatility increases, the value of the callable bond will decrease because the owner will be short the option that will rise in value as the volatility increases. Therefore, Jokinen’s second statement is wrong. This question was from two sample item sets put out by CFAI. http://www.cfainstitute.org/cfaprog/courseofstudy/pdf/sample_levelii_itemset_questions.pdf

Man, I hope we get questions like these.

Geee, I need some rest, I had a correct logic and I picked a wrong answer argggg