If the volatility of interest rates increases, which of the following will experience the smallest price increase resulting from lower rates? A) Callable bond. B) Putable bond. C) Option-free coupon bond. D) Zero-coupon option-free bond. Your answer: B was incorrect. The correct answer was A) Callable bond. For a callable bond the issuer has the option to call the bond if the interest rate decreases during its call period. The issuer will call the bond if interest rates have decreased in order to obtain cheaper financing elsewhere. If the interest rate volatility increases the chance the it is optimal for the issuer to call the bond increases, making the call option more valuable. Therefore, the bond price is depressed by an increase in interest rate volatility. I dont quite understand the logic behind this… somethings not tickin in my head.

If the interest rate volatility increases the chance the it is optimal for the issuer to call the bond increases, making the call option more valuable. That is the key sentence in the explanation. The more volatile the rates, the more likely the bond will be called away from the investor. And the more likely the bond will be called away, the less valuable it is to the investor.

i understand that, but how does that relate to “smallest price increase resulting from lower rates” ??? How is “smallest price increase” relate to a callable bond?

I think i would say that since no investors want to buy anymore callable bonds, lest it gets called back to issuers, the chance of a price increase would be the slimmest among all 4 options.

You should look at the graph for callable bonds. if interest rates decrease, the price of bond goes up but for callable bonds there is an upper limit to the price the bond which is the callable price.the more the price is closer to that callable price any lowering of interest rates will affect less the price of the bond nobody wants to pay 110 for a bond when it’s callable at 105

Florin - If you want to sound in-the-know, it’s “call price” not “callable price” but good analysis. The other way to look at it is that if you own a callable bond you can decompose that into ownining a non-callable bond + short a call option on that bond. When interest rates go down the former certainly becomes more valuable. Unfortunately, the call option also becomes more valuable and you’re short (bummer). That first phrase “If the volatility of interest rates increases” is not even needed here, but makes things even worse if you own the callable bond. By itself interest rate vol increase doesn’t affect the price of the non-callable bond, but it makes the call option more valuable. A volatility increase alone will make the callable bond decrease in price (the puttable bond will increase in price and the zero which has higher duration than the coupon bond will experience more volatility).

goooooootchaaaa thx alot

By the way, what is interest rate volatility ?.. my understanding is… = the upwardward and downward movement of market interest rates in a period of time… am i missing something? Joey says in this statement it is not needed…