amber in that case, my analysis is horribly wrong Hence it must be modified to correct thing. a) price of callable bond = b) price of option free bond - c) price of call option so if int. rates go up, then b goes down, and c goes down as well, then price of Callable bond will go down more than the price of the option free bond. C Someone pleave give the REAL ANSWER.
I would say C. If interest rates increase, that makes the bond less and less “callable”. But as long as the “callable” feature is still there, it is going to be worth something (almost nothing but something).
What’s going on here? First, it’s “MOST LIKELY”. If interest rates rise, the bond call is worth less and less. The owner of the bond is short the call. The bond loses money but the call option also loses money. Of course, the bond loses more than the call (delta on the call < 1) so the bondholder loses money, but not as much as he would lose if he wasn’t short the call. Edit: So it’s B
“If interest rate rise, the price of the bond will go down, and hence there is high probability that the issuer will call the bond.” WRONG – lower rates incentivize a co. to call its debt back.
Joey is right, of course. See pages 484-486 in Vol. 5 If rates were very high, there is a very good chance the callable bond will behave just like a option free bond.
Still no clue on this who is right. I’ve said, B, C and D at some point. I must be right too.
Pepp, read Joey comment he is right.
hmm, yeah. that’s pretty much what I thought when I said B, in my first reponse 
so the theory with “pick the opposite of what seems logic the first time” is not working…
LOL Map!!! ahahah Map, pepp are you both from USA?
not in this case, as I’d try to solve these kind of questions. In this case i’d go with B. Wherever there is ambiguity i’d apply the theory of go with opposite of what i pick first. This question is very good one, only if you know the concept you can actually get it right.
what a $hit show this post is people… don’t over think this stuff… pepp had the right instinct to think about the Price-Yield Function graph then went straight over the deep end… the answer is unequivocally “B” you dont even need to look hard for the graph, Schweser has plastered it on every single book cover and marketing piece of paraphernalia. EDIT: ahh i just noticed Joey has already been here, just listen to what he says
I think it is B rates up, prices down – for normal bonds for a callable, a higher rate means less chance of it being called, so the decrease should be less violent ???