I see. Thanks. If I imagine rates changing from a low yield base, where both the bond and the option have value, the callable bond is less sensitive due to the option’s imbedded value.
reema, that’s two questions I’ve seen from you that have no correct answer. The reinvestment question also had no answer (as there is not enough information). I’d question the standard of your source. >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. FALSE: a callable bond is less sensitive as yields FALL (due to the ceiling at the call price). >B) A bondholder usually gains if a bond is called. FALSE: If the bond is called, it’s usually because yields have fallen, so the investor will have to reinvest at a lower rate >C) As interest rates decrease, the value to the investor of the call option increases. FALSE: As interest rates decrease, the value to the ISSUER of the call option increases. >D) As interest rates fall, the value of a callable bond will exceed that of a similar straight bond. FALSE: The value of a callable bond NEVER exceeds that of a similar straight bond, due to the fact that the value of the call option is <= 0 for an investor.
these questions are from schweser q-bank
Can you post some numbers?
I agree this is a poorly worded question that caused confusion. I believe choice C should read: C) As interest rates decrease, the value of the call option increases to the bondholder Bondholder should be used b/c they used it in choice B above; all of a sudden switching to “investor” and with the way that question was worded caused some confusion. I originally chose A but after seeing people’s reasoning for C, agree that the choices were worded poorly.
rbford Wrote: ------------------------------------------------------- > I agree this is a poorly worded question that > caused confusion. I believe choice C should > read: > > C) As interest rates decrease, the value of the > call option increases to the bondholder > > Bondholder should be used b/c they used it in > choice B above; all of a sudden switching to > “investor” and with the way that question was > worded caused some confusion. > > I originally chose A but after seeing people’s > reasoning for C, agree that the choices were > worded poorly. agree with you totally. it got me confused and so i posted it here
Errr, but that’s still wrong. The value to the bondISSUER increases - the COST to the bondholder/investor increases - the value to the bondholder/investor DECREASES. reema, please post the QBank number for this question, so it can be checked and an erratum report sent to Schweser. Thanks.
Question ID#: 4609
reema Wrote: ------------------------------------------------------- > 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. This doesn’t make sense to me. The bond issuer is the one deriving value from the call option, not the investor. So how exactly does the call option limit the downside of the bond price? … especially as it moves further out-of-the-money? Sure, it still has time value, but again this is a benefit to the issuer only. I’ve been a fan of Schweser products typically, but I think this QBank question isn’t an example of their finest work.
chrismaths Wrote: ------------------------------------------------------- > Errr, but that’s still wrong. > > The value to the bondISSUER increases - the COST > to the bondholder/investor increases - the value > to the bondholder/investor DECREASES. > > reema, please post the QBank number for this > question, so it can be checked and an erratum > report sent to Schweser. > > Thanks. Exactly. It is supposed to be a wrong choice. That is why A is the right answer. But with the way C was worded before, you could argue it was a correct answer if you looked at it from the perspective of the “investor of the call option” being the issuer. Again, we want C to be wrong here, b/c choice A is the right choice. But the way C was worded originally it could appear to be right.
Fair enough. I missed the decreasing value of the call option decreasing the impact of the yield rise. I was thinking about with the call out of the money, should have thought about it in the money. Thanks Ryan - I jumped in without reading closely enough!
hiredguns1, I had an almost identical question on a CFAI practice exam and A was right on that one as well. Remember, you will pay less for a callable bond than an equal non-callable bond because the issuer has the benefit of the call option. As I posted above: Callable bond = Price - call option premium The call option is of less value to the issuer as it moves out of the money. This causes the call option premium in the above equation to go down, which means it will move less than a non-callable bond. When yields rise, price of bond goes down and call option premium goes down.
Okay, after correcting the typo for Option C, A is correct, but I don’t think moto’s comments are clarifying things. Schweser is correct that the embedded call option reduces the price decline of the bond when yields increase, but their explanation isn’t very helpful because they fail to clarify that the option’s impact is *indirect* The callable bond has a lower duration than the straight bond. Why? Well, at the time of issuance, the callable bond must have a higher yield than a comparable straight bond in order to compensate investors for the call option and entice them to actually buy the thing (think of the higher coupon as the price paid to buy the call option from investors). So, with the higher coupon rate, the callable bond’s duration is lower and its price doesn’t decline as much as the straight bond. This makes sense. So let’s assume yields increase, well, the disparity between the new, higher market yields and the yield on the convertible bond is less severe than the difference between the higher market yield and the straight bond. As for moto’s comments: yes, at any given point in time, the bond is worth the price of a straight bond less the value of the embedded call option, but as you pointed out, both price and the value of the option are declining in this case, and the model doesn’t aid us in deciding how much each of them will decline. I don’t think that formula is intended for this dynamic situation, and as the option moves further out-of-the-money, the formula really begins to look like: Callable bond = Price - 0, which as I was saying before, basically removes the impact of the call. Anyway, interesting thread, poor typos and explanations from Schweser. Life goes on. Edit: maybe moto’s right, but his explanation just isn’t registering for me as clearly as how duration rationalizes things.
Can i assume callable bond’s duration is less than risk-free bond? that’s the reason A is true?
achogogo, one fine distinction: yes I was discussing duration as being the explanation, but the bonds involved are a callable bond and an otherwise comparable straight bond. There are more differences between a callable bond and a risk-free bond (particularly w/r/t/ default risk), so I don’t think it makes sense for us to compare these bonds in this discussion where we’re trying to address optionality specifically.