AuthorTopic: CFA mock exam: Callable Bonds question
panvino
@2009-06-02 02:16:47
I am struggling to understand why a callable bond will decrease less than a straight bond if interest rates rise (it was a question on the CFA mock exams). My understanding of the forumula is: price of callable bond = price of straight bond less price of callable option.
My train of thought is as follows: If interest rates increase, the price of a straight bond decreases and the value of the callable option also decreases. So if I deduct even a very small value relating to the callable option from the straight bond, wont the value the callable bond decrease by MORE not LESS than an otherwise identical bond? My only guess is it has something to do with the initial price paid, ie the callable will sell for less than an a straight bond to start off with because of the value to the issuer. If interest rates decreae, the price of a callable bond would increase by less than a straight bond because of the option right? So I would have thought for an increase the opposite would happen. I am going crazy trying to think this one through, any help would be greatly appreciated!
raymondg
@2009-06-02 23:57:15
I am not sure on this one. Tricky but could it have something to do with the fact that the callable bond has a higher yield compared to a option free bond thus reducing duration ?
ckylwy
@2009-06-05 22:58:01
HI HI,

The following is just my opinion to your quesion.

Remember that the call option gave the right to the issue of the bond to call it back when the price is near or above the call price?

That means the interest risk sensitivity (eduration) is less with call option.

because the eduration decreases with the call option, when the interest rate increases, the bond price will decrease less, compared to straignt bond.

How is that?

Steven