Which of the following statements about callable bonds is TRUE? A) When yields rise, the value of a callable bond is less sensitive and will exhibit less of a price change than a noncallable bond. B) A bondholder usually gains if a bond is called. C) As interest rates decrease, the value to the investor of the call option increases. D) As interest rates fall, the value of a callable bond will exceed that of a similar straight bond.
C?
Answer is D. A. Callable and non-Callabale are indifferent at hight yields, It’s only at low yields that callable bonds exhibit negative-convexity B. He loses C. IR decreases —> Price increases —> probablity of the bond being called increases —> so value of the call option increases to the bondissuer and decreases to the investor D. As IR falls (i.e. at high yields), the simple bond and callable bond are indifferent. - Dinesh S
C: At lower interest rate, a call holder is more likely to exercise the option to refund the high coupon bond. Dinesh, if my understanding is correct, indentures of callable bond usually indicate a call price i.e the bonds are not called at market. Most likely candidate of a call price is par or maybe a slight premium to par. As rates decline, value of bond increases beyond the one specified in the indenture as call price, more likely it will be called. (value of call option increases)
I think C is the correct answer
Definitely not C. The value of the call option lies with the Issuer, not the investor. I think its A.
A Callable bond = Price - call option premium If yields rise, price goes down and the value of the call option premium goes down as well.
A? B&C are not true because the value of the call is to the issuer not eh bondhomder or inventor. D, cannot see the value of the callable ever exceeding a noncallable bond. at the ebst it can be equal if the call premium is zero.
A for the same reason that moto376 mentioned.
I’ll go with C. A) As yields rise, both the callable and straight bonds will decrease in value. The embedded call option moves even further out-of-the-money and should not materially affect the callable bond’s value. The callable and straight bonds will be equally sensitive to the yield increase. B) Bondholder never gains from an issuer calling. Rates would likely have fallen, increasing bond value, causing issuer to call and requiring the bondholder to reinvest at a lower rate. C) In this case, the bond issuer has the long position on the embedded call option and is therefore the “investor” in the call option. The value of the long position increases as interest rates decrease. D) As interest rates fall, the callable bond will exhibit negative convexity, it will not rise above the call price, whereas the straight bond has no embedded option to limit its price increase.
I see what you’re saying with C hiredguns1. I’m not sure that the question is referring to the issuer as the investor though.
hiredguns1 Wrote: ------------------------------------------------------- > I’ll go with C. > > C) In this case, the bond issuer has the long > position on the embedded call option and is > therefore the “investor” in the call option. The > value of the long position increases as interest > rates decrease. Hired, you may be right. I didn’t think about it that way. The wording is really tricky on this one. So reema, what is the answer?
I would have been confident answering C when reading the question. After reading this thread, I’m not really sure
i sticking with C
hiredguns1 Wrote: ------------------------------------------------------- > I’ll go with C. > > A) As yields rise, both the callable and straight > bonds will decrease in value. The embedded call > option moves even further out-of-the-money and > should not materially affect the callable bond’s > value. The callable and straight bonds will be > equally sensitive to the yield increase. > > B) Bondholder never gains from an issuer calling. > Rates would likely have fallen, increasing bond > value, causing issuer to call and requiring the > bondholder to reinvest at a lower rate. > > C) In this case, the bond issuer has the long > position on the embedded call option and is > therefore the “investor” in the call option. The > value of the long position increases as interest > rates decrease. > > D) As interest rates fall, the callable bond will > exhibit negative convexity, it will not rise above > the call price, whereas the straight bond has no > embedded option to limit its price increase. I second your reasoning and thats precisely what i thought. But the official correct answer is A …ill post the explanation later in the day.
A
Answer is clearly A; B- Bondholder doesnt gain if bond is called because rates must be low, thus the face value must be invested at a lower rate C- As interest rates decrease, the higher the probability the bond will be called, this is bad for an investor D- As interest rates fall, the price of a callable bond is capped at the strike price. An option free bond would have a higher price.
My vote is for C because: As yields rise, the callable bond’s option is worthless; therefore bonds bonds will move together. There is no reason to assume the callable bond is “less sensitive.” B He loses b/c of reinvestment risk C As rates decrease, the value of the callable bond’s option increases, and in this case, the investor IS the issuer; hence the value to the investor increases. D As rates fall, the value of the option increases, not the bond itself.
Yancey - I think the best way to think about this is to imagine rates are rising from a really low base. Here the call still has value and the yield curve for the callable bond is much flatter. Thus for a given increase in rates the price will fall much less for a callable bond, than an option-free bond (i.e. the callable bond is less sensitive) Yes, as rates get higher, the effect becomes less pronounced, but given that the callable bond will never be worth more than the option free bond, it is probably fair to assume this effect holds for all levels of interest rates.
ok guys the answer is A and the explanation is (which i still dont agree with ): When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. With a decrease in interest rates, the value of a callable bond can increase to only approximately the call value (the call price serves as a cap or “ceiling.”). Straight bonds will continue to exhibit the inverse relationship between yields and prices, as there is no “ceiling” call price. A bondholder will most likely lose if a bond is called, because a bond is most likely to be called in a declining interest rate environment. The issuer will likely call the bond and replace it with lower cost (lower coupon debt). The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments. The statement that begins, “As interest rates decrease…,” should continue, “… the value to the issuer of the call option increases.” As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt.