Convexity........

CFA Level I
#1

At yield levels that are high relative to bonds coupon rate, is the price of the option free bond higher then the price of an otherwise identical (Yes or NO question) Call bond … Put Bond ?..?

#2

yes - no ?

#3

yes --------- no call bond: bond - short call putable bond: bond + long put for an increase in interest rates: call increases put decreases

#4

Thank you both for reply. I get the call part but for some reason can get the PUT answer to set in. Can you break down?

#5

I do not understand how a Call Bond would be more valuable when interest rate increases. Wouldn’t the bond get called when rates fall? CP

#6

cpk, the value of the embedded call option will ALWAYS be worth something, which means the price of a callable bond will always be less than that of an option-free one

#7

That is fine, but what is being said above is as interest rates rise, price of the Call Increases – that I understand, but price of Callable bond should FALL due to two effects. PNCB falls, Call Option Value Increases–> So PCB = PNCB-Call FALLS. (Does not increase) PNPB Falls, Put Option Increases as Interest Rates increase – So PPB Increases. So a Callable Bond would be Lower in Price than a Option Free Bond **** NO Putable Bond – Higher in Price than an Option Free Bond *** Yes

#8

I fell for the question… :frowning:

#9

cpk, I think it is a trick question. It is not asking what happens to the value of the option (and hence the bond) as yields move up, it is just asking what the price of the bond with the option would be priced at given the yield. I believe this could be at any yield. At any yield, the price of option-free bond will always be higher than a similar bond with an embedded call option, and lower than a similar bond with an embedded put option.

#10

ok… hope they say TRICK in BOLD and RED when they give this to us… :slight_smile: I am sick and tired of the trick questions. CP

#11

CPK i think Finance 03 is right. I was looking at this question from your perspective as well but their answer is the correct one. The question that Finance 03 just formulated is the one I am personally more interested in.

#12

thanks guys…:slight_smile: now i got confused too. thought i nailed it but now i’m not sure anymore… i’m off to bed. good night. barthezz

#13

Guys I’m really confused on this now. Please help me sort this table I created. Does it look right? Option Free (OF) Callable Bond Putable bond Yield goes UP Price Falls Price falls by less(OF) Price falls by less(OF) Callable bond price < OF Putable bond price > OF Call value decreases Put value increases Yield goes DOWN Price increases Price increases by less(OF) Price increases by less(OF) Callable bond price < OF Putable bond price > OF Call value increases Put value decreases

#14

I think my table lost shape so now it make no sense.

#15

Que is When rates are higher than coupon Part A Is option Free Bond (B) > Callable Bond (B-C) Ans: Yes, No matter what happens to the rates, a callable bond is always worth less to the investor than a (similar) option free bond as the investor is short an option. The issuer has the option to call. Part B Is Option free bond (B) > Puttable bond (B+P) Ans: No Since the investor is long the option, puttable bond is worth more in any rate scenario. Especially in this one, 'coz the investor can potentially put the bond and reinvest at higher rate. I guess the key here is to realize that the question is being asked from an investor’s perspective