if interest rate is expected to increase, what are the expected performances of bullt, putable and callable?
A. both callable and putable outperforms bullt
B. both underform
C. callable underperforms bullet, putable outperforms bullt
C.
reasoning -> rates increase - so Bond price drops. It will not get called by the issuer, but the investor in the Put will put the bond back to the issuer to receive par.
from the perspective of the investor - callable underperforms - he continues to hold an asset that is going down in value. A Putable outperforms - since he would put it back at par. (and hence make a profit).
A. Putables outperform because the put increases in value as you own it and can put the bond back at par
Call falls less than a normal bond when rates increase. To be precise it depends how far out of the money the call is, if this is starting at par then what i said is true, if you are already heavily discounted then the callable is pretty much completely poistive in terms of convexity and will behave the same as the non-callable.
CP:
I chose C as well. take a look at CFAI answer:
Answer is A
Callable bonds will outperform bullet maturities as the probability of an early call diminishes with rising interest rates. Putable bonds will outperform bullet maturities because investors can avoid losses associated with rising interest rates by putting the bond back to the company.
My question is this:
If i am looking at a graph showing payoffs a callable bond+putable bond (aka the graph showing negative convexity and positive convexity), where does the bullet bond sit?
Callable will outperform the bullet due to the yield pickup (callables have a higher yield than bullets under almost all circumstances to compensate for the call option the issuer has). The duration of a callable bond is also normally shorter than that of a bullet at lower rates and cannot be longer than a bullet, resulting in less of a price decrease. The puttable bond will outperform a bullet because it has a floor value at the put price. If rates rise, the price cannot fall below that put price.
its always confusing abt callables…
One way they say negative convexity which means price decrease would be more than the price increase given the same % change in yields. Ok understood but then they compare it with bullets.
Like in the question, if int rate increase, bonds should go down as per general characteristics. Here putables will outperform bullet coz they could be put back at par so there price would not fall as much as bullet bonds.
I have a problem in understanding Callables performance when int rate goes up/down?? If int rate goes up, this should fall more due to -ve convexity. But then they say call option goes out of option due to int rate increase, so callables should behave like a normal +ve convexity bond. Overall callable should perform equal to bullets. However there is one argument that due to yield pick up callable would outperform bullets.
A - if they are all the same maturity.
Bullet underperforms callable with the same maturity, because it would have the higher duration.
Putable outperforms both becuase it has a floor.
DUDE BUMP! LEVEL 3 ONCE is god.
I would have said C due to negative convexity.
this CFA malarkey is depressing
The correct answer is that _ it depends _.
If interest rates start low enough that the callable bond is in the region of negative convexity, then the callable will outperform the straight bond. If interest rates start high enough that the callable bond is in the region of positive convexity, then the callable bond won’t outperform the straight bond.
As with many other areas of the curriculum, this one is pretty easy to understand if you draw a picture.
I agree with S2000magician above. However, I came across this statement from the L3 curriculum:
“…The rapid descent of the US yield curve contributed to underperformance of high-coupon callable structures because of their negative convexity property.”
I’m assuming that since coupon is high, interest rates start high enough, so callable bond are not expected to underperform nor overperform bullets due to convexity alone. However, if there is a rapid descent in yields, volatility increases, call option value increases, and bond prices decrease relative to bullet. Underperformance should be caused by the bond’s sensitivity to volatility, not its negative convexity, right?
Ugh I totally mixed up descent with ascent. I understand the statement now. Please ignore above. Haha.
in my opinion, callables which give investors the benefit of a higher coupon than they would have had with a non-callable bond should be more favoured by investors when the probability to call has dimished.
Liming