Qbank Q:Interest rate affects on callable and putable bonds

Question and then my comment below: Wall believes he understands the relationship between interest rates and straight bonds but is unclear how callable bonds change as interest rates increase. How do prices of callable bonds react to an increase in interest rates? The price: A) decreases. B) may increase or decrease. C) increases. Your answer: C was incorrect. The correct answer was A) decreases. Since the bond has a fixed coupon it becomes relatively less attractive to investors when interest rates increase. Its cash flows are now discounted at a higher discount rate which reduces the value of the bond. (Study Session 14, LOS 54.e, f) I am not getting this. When rates go down there is a higher chance that issuers will call the bond, so I would think that low rates make callable bonds unattractive. Therefore, it seems that an INCREASE in interest rates would make callable bonds more attractive/less risky for the investor. Why then does the Q say that the price of callable bonds will decrease?

there is a difference between a call on a rate and a call on a bond price call on a bond price, high rate, low price, low call value call on a rate, high rate, high call value generally when talking about callable bonds we’re talking about rate so high rate: straight value will drop call value will increase both will cause the callable bond value to fall i think so anyway? EDIT: having looked at my notes i think i’m wrong but if rates go up, the callable bond is less likely to be called as price will be lower so same result

tenten Wrote: ------------------------------------------------------- > Question and then my comment below: > > > > > Wall believes he understands the relationship > between interest rates and straight bonds but is > unclear how callable bonds change as interest > rates increase. How do prices of callable bonds > react to an increase in interest rates? The > price: > A) decreases. > B) may increase or decrease. > C) increases. > > Your answer: C was incorrect. The correct answer > was A) decreases. > > Since the bond has a fixed coupon it becomes > relatively less attractive to investors when > interest rates increase. Its cash flows are now > discounted at a higher discount rate which reduces > the value of the bond. (Study Session 14, LOS > 54.e, f) > > > > > I am not getting this. When rates go down there > is a higher chance that issuers will call the > bond, so I would think that low rates make > callable bonds unattractive. Therefore, it seems > that an INCREASE in interest rates would make > callable bonds more attractive/less risky for the > investor. Why then does the Q say that the price > of callable bonds will decrease? Just because they are more attractive doesn’t mean it will overpower the effect of interest rates on the bond price.

non-callable bond = callable bond + option cost. Volatility always increases the option cost. Hence, all things being equal the callable bond price should decrease.

wisprud Wrote: ------------------------------------------------------- > non-callable bond = callable bond + option cost. > > Volatility always increases the option cost. > Hence, all things being equal the callable bond > price should decrease. It should be callable bond = non-callable bond + option cost

no… callable bond = non-callable bond - option cost reason: Call is at the option of the issuer. he must make it worth investor’s while to invest in a callable bond. putable bond = non-putable bond+option cost. put is at the option of the investor. Please correct me if I am wrong here.

cpk123 Wrote: ------------------------------------------------------- > no… > > callable bond = non-callable bond - option cost > > reason: Call is at the option of the issuer. he > must make it worth investor’s while to invest in a > callable bond. > > putable bond = non-putable bond+option cost. > put is at the option of the investor. > > Please correct me if I am wrong here. Oh yes you and wisprud were correct. My mistake.