When rates rise CFAI states that the callable outperforms a bullet 'cos the call optionality diminishes. But, isn’t it true that a callable bond like another bullet begins to display positive convexity when rates rise, in other words performance of a callable and bullet must be the same when rates rise?
Yes, but the Call option will decrease in value which will give a boost to the price of the bond.
Also, wouldn’t the coupon probably be higher on the callable to compensate for the option, thus adding to the total return??
Big Babbu Wrote: ------------------------------------------------------- > Also, wouldn’t the coupon probably be higher on > the callable to compensate for the option, thus > adding to the total return?? i agree.
trymybest, you are right. but for exam pupose we need to rememeber CFA point of view (for some reason they consider only negative convexity region). this problem was already discussed
Here is the rationale. Although they display positive convexity (when rates rise), you get a higher coupon due to the callability feature (or you would have bough for a higher relative yield, all things equal). So even if the rates rise and effect both in a similar way in regard to pricing (% change), you will still be getting a higher yield (bid side) relative to the bullet and a higher coupon.
thinking about it, the question did not say the rates fell below the coupon or the rates fell all the way…I think +ve convexity is displayed when rates are below coupon and very low else if rates are above coupon and rates decrease then the performance of a callable will be greater than that of a bullet!