Okay, so my understanding of a call option when it comes to bonds is that the bond issuer has the right (but not obligation) to pay off the debt early. Presumably, they would only do this if interest rates have gone lower than they were at time of issue. Am I right?
Let’s pretend Blackberry is struggling and issues bonds paying 5% with call options. If PMT =50, FV 1000, and price = 950, then we can assume that the call option had an intrinsic value of about 50 dollars, right? If prevailing rates fall to 3%, that call option is going to be worth more than $50
A book states:
Adding a call provision will decrease a straight bond’s interest rate risk as measured by effective duration. With a call provision, the value of the call increases as yields fall.…
The bold part makes sense.
.…so a decrease in yield wiill have less effect on the price of the bond, which is the the prie of a straight bond minuse hte value of the call option.
I’m not sure how that makes sense. Wouldn’t the presence of the call option have a BIGGER impact on the bond value since it severely limits your upside as a bond purchaser?
The bond issuer has the right to exercise call option on a bond at the strike price given . As the interest rates go down and the price of the bond goes up , the bond issuer can exercise his right to call the bond.
There might be other reasons that they’d call the bonds early, but lower interest rates is the most likely reason.
The intrinsic value of the call option will depend on the price at which they can call the bonds, which is usually at a premium to par. In any case, if the bonds are issued at $950, even a call option at par will have an intrinsic value of $0: why would you call a bond and pay $1,000 for it when you could buy it on the open market at $950?
If interest rates drop to 3% the option will be in the money. How much would depend on the maturity of the bonds.
What they’re saying is that the price change of a callable bond when interest rates change will be less than the price change of an option-free bond for the same interest rate change. As you point out, the call option limits the upside; that’s exactly what lowers the price change.