# Embedded Call Option Q

How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call: A) increases. B) decreases. C) remains the same. D) may increase or decrease.

A

Is it D … because of the negative convexity nature of callable bonds when IR rises? The call value will be capped at some interest rate

This is a bond call right? So in general if interest rates increase, bond becomes worth less money, i.e., price goes down => call option worth less. There is a little issue of rho of the option in there which is a small counter to that but the answer is generally b.

JDV got it - Your answer: A was incorrect. The correct answer was B) decreases. Since the underlying asset to the option (the bond) decreases in value the option must decrease in value also. T/G

I didn’t even read the question right…I thought it had to do with volatility…too many careless mistakes.

of course B

Holy crap. What have I written. I need to review FI now!

JoeyDVivre Wrote: ------------------------------------------------------- > This is a bond call right? So in general if > interest rates increase, bond becomes worth less > money, i.e., price goes down => call option worth > less. There is a little issue of rho of the > option in there which is a small counter to that > but the answer is generally b. This would be seen in the put/call parity equation with the discount bond right?

no, mwvt, this is a different situation. Call option allows bond issuer call it at a certain price. If interest rates go up, bond price goes down and there is less incentive to call the bond (or buy it at a prespecified price).

I know that. LOL I am talking about the rho thing that JDV was referencing. From put/call parity: C=S+P-X/(1+r) In this equation are r goes up the value of the call goes up. Is that the slight offset he is referring to?

b - it goes down. when interest rates increase, the likelihood of this bond getting called diminishes. it’s less likely to be used and it’s value is lower. i assume this is the value to the “issuer of the bond”.

mwvt9 Wrote: ------------------------------------------------------- > I know that. LOL > > I am talking about the rho thing that JDV was > referencing. > > From put/call parity: > > C=S+P-X/(1+r) > > In this equation are r goes up the value of the > call goes up. Is that the slight offset he is > referring to? Yeah - its just an issue of “interest rates go up” that is a bit unclear