# Call Option Value

Tomoko now turns her attention to the value of the embedded call option. How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call: A) decreases. B) increases. C) remains the same. Shouldn’t answer to this one be (B) “increases”?

When rates increases, the value of bond decreases.

Yes. If we sell the call option, we must borrow in order to replicate the option to hedge it. Thus, higher rates result in higher borrowing costs and more expensive replicating portfolio. This of course assumes that only rates change. It is often the case the rate increases will result in asset price decreases or something similar which could offset direct int. rate effects.

that’s true for a bond. But increase in interest rate increases the value of call option, right? So, answer should be B?

it depends… stock would increasse, bond decrease… this is asking about embedded value, so they are referring to bond

increase in volatility increases the value of the callable bond. Volatility can take you either way. We need an FI expert here

The question is asking for the value of the embedded call, not the bond itself. It should be B

V_call = V_noncallable - V_callable. As interest rates go up, V_callable go up, so V_call goes down.

mp2438 Wrote: ------------------------------------------------------- > V_call = V_noncallable - V_callable. > > As interest rates go up, V_callable go up, so > V_call goes down. The value of callable bond will go up when rates decrease, but hits a ceiling as opposed to an option free bond.

CFAdreams Wrote: ------------------------------------------------------- > it depends… stock would increasse, bond > decrease… this is asking about embedded value, > so they are referring to bond No, it doesn’t matter. A call option is a call option, whether on a bond or equity. The seperate value of the option itself will increase, but it may be offset by a decline in the underlying.

I would say A - the value of the call decreases, since the issuer would be less likely to call the bond, hence less value to the issuer.

increase in rate volatility will increase both call and put option value, humm, but what about increase in the interest rate itself? this is an excellent question, anyone knows the answer?

wyantjs Wrote: ------------------------------------------------------- > CFAdreams Wrote: > -------------------------------------------------- > ----- > > it depends… stock would increasse, bond > > decrease… this is asking about embedded > value, > > so they are referring to bond > > > No, it doesn’t matter. A call option is a call > option, whether on a bond or equity. The seperate > value of the option itself will increase, but it > may be offset by a decline in the underlying. My bad, i was talking about the bond as a whole… wasnt specific enough