Hey Guys, i need your help to understand the following: Unlike a noncallable bond, a callable security’s duration, or sensitivity to interest rate changes, decreases when rates fall and increases when rates rise. The spread or difference in yield over comparable noncallable securities compensates callable investors for this “negative convexity.” I’m trying to google it but can tseem to find a good explaination. Thanks
The “unlike a noncallable bond” part is not true as the duration of a noncallable bond changes when interest rates change. However, what they mean here is that with a non-callable bond everytime interest rates decrease by, say, 10 bp you make money. Further, you will make even more money if they decline by another 10 bp. For a callable bond that’s not true because as interest rates decrease, it becomes more and more likely that the bond will be called. Eventually, it becomes certain the bond will be called and then further decreases in interest rates have no effect on the price of the bond.
Thanks Joey, inaddition to your anwser i reread the chapter and it seems to be making better sense now. Cheers
Nice - keep it going.