If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-free bond, will most likely: A. increase by less than the option free bond B. decrease by less than the option free bond C. decrease by more than the option free bond D. decrease by the same amount My guess is A…seeking confirmation
If market interest rates rise, this will have an inverse effect on the price of the bond, so I doubt it is A. The key to the question is that if rates were to be lower, then the issuer may choose to call (as in redeem) the bond, on the premise they could re issue debt at the lower market rate prevailing at that time…Have another go, before we give the correct answer.
Callable Bond (CB) = Option-Free Bond (OFB) - Call If Int. Rates go up -> Price of OFB goes down If Int. Rates go up -> C also goes up Therefore the CB goes down more than the OFB
B Price of option free bond and the call option both decrease. Thus, the price of the callable bond decreases by less than the price of the option free bond. If rates increase, the value of the call option decreases because it is less valuable to the issuer, i.e. the issuer is less likely to call a bond when rates increase.
I vote C. price of a the call going up drags down the price of the bond.
changing my answer to B
From the CFAI text, Reading 63: “Similarly, when interest rates rise, the price of a callable bond will not fall as much as an otherwise option-free bond. The reason is that the price of the embedded call option declines. So, when interest rates rise, the price of the option-free bond declines, but this is partially offset by the decrease in the price of the embedded call option component.”
JUT111, If rates go up, I would have thought the value of the call would fall as there is more of a chance the issuer redeems the issue at lower rates and we are further away from that point.
I will go with D. As the curvature for the lower portion of the yield-curve remains same for Callable and option-free bonds.
your right perdition - i think i messed that up. I change my answer to B
Less than a month to go and such a question is causing so much confusion? This question is essentially testing your knowledge on the duration and convexity differences between option-free and optionable bonds. You are supposed to know that optionality causes negative convexity, which in turn leads to decreasing duration for bonds with options as rates fall. I think we’re supposed to assume the bond in the question currently exhibits negative convexity, therefore the duration of the bond should be less than that of its option-free counterpart. This means what for a given change in rates, the price of the callable will change less than that the option-free bond. In this example, rates are rising, so the price of the bond is falling. Therefore, the correct answer is that the callable bond will fall less in price than the option-free bond.
Agree on B, the trap was D
Agree with CFA_2010. The decrease in the value of the “Call” feature, offsets the price of the OFB. So B. Yes perdition, I am the unfortunate victim of the trap.