Two bonds with identical maturity, coupon size and default risk are selling at par value. The first bond is an option-free bond. The second bond is a callable bond. In response to a 100 basis point decrease in required return:

A. the price of the first will increase by more than the price of the second.
B. the price of the second will increase by more than the price of the first.
C. the price of the first will decrease by more than the price of the second.

Correct Answer: A

The call provision of the second bond will mute the price increase due to a decline in the level of interest rates. As the level of interest rates decreases, it is more likely that the issuer of the callable bond will exercise its option.