 # Fixed Income question

I’m a little confused with this very simple question Tina Donaldson, CFA candidate, is studying yield volatility and the value of putable bonds. She has the following information: a putable bond with a put option value calculated at 0.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 99.0. Donaldson also wants to determine how the bond’s value will change if yield volatility decreases. Which of the following choices is closest to what Donaldson calculates as the value for the putable bond and correctly describes the bond’s price behavior as yield volatility decreases? A) 99.75, price increases. B) 99.75, price decreases. C) 98.25, price decreases. D) 98.25, price increases. The correct answer was B) 99.75, price decreases. To calculate the putable bond value, use the following formula: Value of putable bond = Value of straight bond + Put option value Value of putable bond = 99.0 + 0.75 = 99.75. Remember: The put option is added to the bond value because the put option is of value to the bondholder, not the issuer. As yield volatility decreases, the value of the embedded option decreases. The formula above shows that for a putable bond, a decrease in the option value results in a decreased bond value. I understand that if yield volatility decreases that the value of the embedded option decreases, which therefore ultimately decreases the bond value but what happens to the value of the straight bond when yield volatility decreases. Would that lead to an increase in price of the straight bond, which would lead to an increase in bond value. Maybe I need to go back and read over Fixed Income. Any assistance would be greatly appreciated.

Where did you get this question ? Straight Bond: When yield volatility decreases the required rate of return (and hence the required yield) will decrease too and hence increase in price of the bond.

When Interest rates fall, the price of a straight bond would increase, but that of a bond with an embedded option would increase at a slower pace. The Put Option itself loses value. So, in all, net effect is that the Price of the Option embedded put bond is lower, when the interest rates decrease.

CPK - But in the above question it states “yield volatility” decreases which in itself doesn’t explicitly mean decrease in yield on bond. ??

JoeyDVivre Wrote: ------------------------------------------------------- > "Volatility, however, is important in the value of > an embedded option. Think of the option on a stock > with market price X and strike price X. In a > stable market, does that option really mean much > to the investor? Not really. " > > Let me know when you are ready to start giving > those away when they don’t mean much. “Yes, well > I know that gamma is approximately infinity, but > these options don’t mean much in this stable > market environment”. Where have you been? I had a major clearance sale last Saturday–and I’m all out of stock. But seriously, I don’t doubt that options have a purpose. It’s like insurance on your car. If you get into an accident, that policy looks very meaningful. If you’re a safe driver and pay your premium every year but never file a single claim, you end up cursing the insurance company for making money on you. It’s all relative I guess.