Value of call = value of noncallable bond - value of callable bond What is the impact of interest rates on the value of the call. Does a rise in interest rates increase the value of the call, which means the value of a non-callable bond also increases? But when interest rates rise, don’t prices of bonds fall (given the inverse yield and bond price relationship)?
The call option is more valuable when interest rates decline. If you draw a graph of price vs. YTM for an option-free bond and a callable bond, you’ll see that they’re virtually identical when YTM is high, but that the callable bond is much less valuable than the noncallable bond when YTM is low; that difference is the value of the call option.
1.Why is the call option more valuable when interest rates decline? 2.Have also seen that an increase in interest rate volatility will increase the value of the call. 3.And in the options reading, it says call options increase in value as the risk-free rate increases. No’s 2. and 3. seem to opposite to 1.?
The option’s in the money: it’s more valuable to call bonds paying a 6% coupon when interest rates are at 2% (so you can refinance at 2%) than when interest rates are at 8%.
As with all options, the value increases when the volatility of the underlying increases, as that makes it more likely that it will move farther in the money.
For options on stocks and gold and wheat and stuff, the risk-free rate is associated with put-call parity, but is not part of the underlying asset for the option. For options on bonds, interest rates in essence _ are _ the underlying asset.
That’s very helpful. Thanks. Last thing on this topic, Schweser says: the arbitrage free value of the noncallable bond is unaffected by increased volatility. value of noncallable bond = value of callable bond + value of call When volatility increases, and the value of the call increases, doesn’t this increase the value of the noncallable bond? Thanks
No: the value of the callable bond decreases by the same amount as the call option increases; the net is zero.
Yeah i understand if value of call goes up, value of callable goes down. But what happens to non-callable bonds? As value of call increases, then does the below also increase? value noncallable bond = value of callable bond + value of call
I think that you didn’t read my previous answer:
If the volatility increases and the value of the call option increases by $50, then _the value of the callable bond drops by $50 _, so the value of the noncallable bond doesn’t change: -$50 + $50 = $0.