It might be late and i’m getting sick of this but here’s the question 92. Bill Johnson is evaluating callable bonds for a portfolio and thinks yields will be more volatile than the market implies. He has the option of investing in option free bonds of the same credit quality at $100, but is considering going with the same issuer’s callable bonds currently offered at $98. Which statement best supports the action Johnson should take? A. Purchase the $100 bonds to lock in a yield over a longer period of time. B. Purchase the $98 bonds because the value of the embedded option is underpriced. C. Purchase the $98 bonds because the convexity coming from their call feature will mute the effects of rate changes. D. Purchase the callable bonds at $98 and allow the volatility in the market to provide him an opportunity for excess return. The answer is B, to purchase the bond because the option is underpriced. But if the option is underpriced, doesn’t that mean the value of the bond will go down??? Callable Bond = Noncallable - value of the option.
in situations with high yield volatility the price of a callable bond will drop but that means that yields will rise.
but he would of already paid 98 for it, what does it matter if the price drops to 96 and it is trading at a higher yield?
Yep, they are wrong. If volatility is higher than the market thinks, the last thing in the world you want to do is be short options.
I would go with A on this one. If there was an option to purchase a putable bond, I would think that would be the best option with volatility rates. Is that right Joey?
I’m curious what the answer is. If the price = optionfree - callable_option, then you’d expect the callable_option to go up, driving the overall price down. In other words, it is overvalued at 98. I was hoping to see answer choice that would let you sell the 98 somehow. Hrm.
I think A too. If implied volatility is higher, then the Callable Bond’s priced is currently overpriced, why would you buy it?