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
Post the official answer
increasing rates means that a NONcallable bond will DECREASE in value. If it is decreasing in value then the value of the call option itself will DECREASE because for bonds, the call is a ceiling when rates fall raising the bond value as a whole. alternatively, In this example, we can all agree that a noncallable bond will decrease in value. Now remember that a callable bond is always worth LESS than a noncallable bond. So what would cause the difference? the value of the call option. This means that the decrease in the noncallable bond is reflected in the decrease in the call option of the callable bond therefore call value goes down.
deep2002 Wrote: ------------------------------------------------------- > increasing rates means that a NONcallable bond > will DECREASE in value. If it is decreasing in > value then the value of the call option itself > will DECREASE because for bonds, the call is a > ceiling when rates fall raising the bond value as > a whole. > > alternatively, In this example, we can all agree > that a noncallable bond will decrease in value. > Now remember that a callable bond is always worth > LESS than a noncallable bond. So what would cause > the difference? the value of the call option. This > means that the decrease in the noncallable bond is > reflected in the decrease in the call option of > the callable bond therefore call value goes down. Increase in call option = decrease in price of a callable bond P(CB) = P(NCB) - C
cfaboston28 Wrote: ------------------------------------------------------- > Post the official answer This is from schweser: 1. Tomoko is a little confused over the relationship between the embedded option and the callable bond. How does the value of the embedded call option change when interest rate volatility increases? The value: A) may increase or decrease. B) decreases. C) increases. 2. Tomoko wonders how the value of the callable bond changes when interest rate volatility increases. How will an increase in volatility affect the value of the callable bond? The value: A) decreases. B) increases. C) may increase or decrease. 3. 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. 4. Tomoko believes her understands the relationship between interest rates and straight bonds but is unclear how callable bonds change as interest rates increase. How do prices of callable bonds react to an increase in interest rates? The price: A) may increase or decrease. B) decreases. C) increases.
An increase in interest rates will decrease the value of the embedded call because it will bring the call further out of the money. A call on a bond increases in value when interest rates decrease. This hurts the bondholder and will decrease the value of the bond to the bondholder but increase the value of the bond to the issuer. An increase in interest rates will increase the value a Call option on a Stock.
Sabaruch, I meant post the answers or give us the q-bank question number.
This is a bond, its not the same thing as calls on stocks. On a bond, the call option decreases in value when rates rise.