Ok…so I think I have all of the damn terms right… just been thinking about one concept though. Assuming we have a Callable Bond 1. With an increase in interest rate volatility - The value of the call increases and the Value of the Callable Bond decreases. This is understood as V (Callable Bond) = V (Non-callable Bond) - Value of Call 2. When an increase in interest rates - What should happen to the value of the Callable Bond Just did some Schweser questions…and here’s my question … When Interest rates rise, the Value of a Bond decreases, but in the case of a Callable Bond, even the value of the Call Option would decrease (according to Schweser - since the price of the underlying asset decreases). So isn’t the net effect on the Value of the Callable bond undeterminable (if that’s even a word!!!), since the two MIGHT offset each other…!!!
to a certain degree yes . what you have to keep in mind is that if interest rates increase the callable bond tends to trend likean option free bond… and I think that gives you the answer.
i agree with florinpop, the value of the bond (the option free value) will decrease more than the value of the call will decrease netting to an overall decrease in the callable bond price
ok…that was my basic understanding…but just wanted to confirm… thanks to both of you… also florinpop, can you give some insight on why a callable bond tends to trade like an option free bond during times of high interest rates?? or rather, why the value of the option free bond decreases more than the value of the call??
when interest rates are high the bond won’t be called so call value tends to be 0, there isn’t really a perceived risk to holding that bond (prepayment risk). because of this I believe that bond must decrease more than the decrease of the call value
It’s kinda theoretically possible for interest rates to increase and the value of the call to decrease less than the value of the bond. That can’t be because of option delta as the option has to have delta < 1 but it could be because of option vol. I guess you can imagine some situation in which option vol decreases a lot while interest rates increase so that value of the uncallable bond decreases but the value of the option decreases by more. Maybe…
gonna go with florinpop’s theory…!! kinda makes most sense… hoping they won’t give a twisted situation like yours JDV!!
Well, i certainly have seen similar situations in equity options…like in the 87 crash when GM for example was down several dollars and (formerly) ATM calls were up from where they traded the day before.
Yeah but that’s the oppposite situation in which the vol is increasing. Having something move and having the vol decrease is pretty unusual. Also, '87 crash examples are almost by definition unusual examples. S&P futures and S&P cash were off by some huge number of points during the day. Markets just weren’t working very well that day.
Agreed its the opposite…and not to get too far off the subject…but generally, moves to the upside will see vol deflation, and you will see many times when earning come in better than expected and equity prices flying, with out of the money calls trading at lower prices because volatility was so pumped. that does happen all the time. as far as markets not working well, there were law suits for years because market makers were selling puts in spx and oex which were effectively allowing them to buy the index for less than zero…e.g. selling the 200 strike put for 210. (a fool and his money)
petetini Wrote: ------------------------------------------------------- > Agreed its the opposite…and not to get too far > off the subject…but generally, moves to the > upside will see vol deflation, and you will see > many times when earning come in better than > expected and equity prices flying, with out of the > money calls trading at lower prices because > volatility was so pumped. that does happen all > the time. That’s certainly true - resolved uncertainty can make vol decrease and underliers move. > > as far as markets not working well, there were law > suits for years because market makers were selling > puts in spx and oex which were effectively > allowing them to buy the index for less than > zero…e.g. selling the 200 strike put for 210. (a > fool and his money)
wow…87…I was like…5 years old and my biggest worries were…well…there were no big worries then…