Which of the following statements is most accurate concerning a convertible bond? A convertible bond’s value depends: A) only on interest rate changes. B) on both interest rate changes and changes in the market price of the stock. C) only on changes in the market price of the stock. Your answer: C was incorrect. The correct answer was B) on both interest rate changes and changes in the market price of the stock. The value of convertible bond includes the value of a straight bond plus an option giving the bondholder the right to buy the common stock of the issuer. Hence, interest rates affect the bond value and the underlying stock price affects the option value
It is the fault of the question to actually clearly tell if its a noncallable bond or callable. For that matter, noncallable bond does not get affected by interest rate volatility whereas it does get affected by interest rate changes. (I would leave it to other commentators to think upon if volatility and absolute changes in interest rates are the same? I think they are the same, so the confusion lies over here). Convertible option gets affected by stock price VOLATILITY. If the Bond were to be callable as well, the call/put option with the convertible bond would be affected by interest rate VOLATILITY.
2 bonds issued by 2 identical companies but in 2 different countries that are identical except for their interest rates. country A has very low interest rate volatility, country B has very high interest rate volatility. investing in A bonds is safer in terms of rate risk, so you’d expect prices to reflect that. additionally B bonds would have more upside potential so you could argue this would also affect prices rate volatility WILL effect bond prices, callable or noncallable
kurupt1: I think you need to look into this again: LOS 54 (f) shows that the arbitrage free value of a noncallable bond is not affected by volatility in interest rates in the equation of a callable bond. Whereby the call option value increases and the callable bond value decreases.
haha fair enough im overthinking
never mind, it does happen to me too. am finishing Fixed Income soon and starting Derivatives & PM today, which is why I had this concept afresh in mind. =)
interest rate changes and volatility are not same. rates can change and historical vol will be zero. and on the other hand rates do not change t0 compared to t1 but vol will be there. rates fluctuate, that is vol.
pfcfaataf Wrote: ------------------------------------------------------- > interest rate changes and volatility are not same. > rates can change and historical vol will be zero. > and on the other hand rates do not change t0 > compared to t1 but vol will be there. rates > fluctuate, that is vol. i think you are overthinking this. i think interest rate changes and volatility are the same (maybe not technically but for purpsoes of this topic). the reason the answer is B is for one of two reasons: 1) it is implied that the convertible bond is also callable, inwhich cases itnerest rates do affect the value of the bond 2) interest rates and interest rate volatility affect investor’s decisions on whether or not to convert the bond to a stock. therefore, interest rates do indirectly impact the convertible bond value. i am leaning towards reason 2. any ideas?
well, i tried to explain you what volatility is. without success as I can see. gl
pfcfaataf Wrote: ------------------------------------------------------- > well, i tried to explain you what volatility is. > without success as I can see. > > gl can you show me where in the text it says that the two arenot the same? i assume you are implying that while interest rate volatility will not affect a noncallable bond, changes in interest rates do. thats why B is right. correct?
interest rate change and interest rate volatility are not the same. if they were the same - why do you effect of I (Interest on the Puts/Calls) and Effect of V(Volatility) on Puts/ Calls?
Based on your guys help here I have written up some notes toadd to my list, can you please comment and let me know if all is accurate and if anything may be added, thank you Interest rate VOLATILITY up = Vcall up and Vput up Interest rates up = does not affect Vcall directly but makes Vcallable go down due to inverse price/rate relationship (and thus Vcall down, because of Vcallable = Vnoncallable - Vcall) While convertible NONcallable bonds are not affected by interest rate volatility (only stock price volatility), they ARE affected by interest rate changes.