CFA Practice Question

CFA Practice Question

With a callable bond, when rates decline the price of the bond increases at a ______ rate and eventually does not change at all.
A. positive
B. faster
C. slower
Explanation: When interest rates decline, there is an increase in the probability that a bond will be called by the issuer. As with a noncallable bond, the price of the bond initially increases with a decline in market rates as investors seek to own a security that will pay a fixed amount of coupon interest. However, with a callable bond there is an offsetting likelihood that investors will not have much time to enjoy this fixed coupon interest because the issuer will be calling the bond back. This depresses the bond's value to an investor. The reason that the issuer will call the bond back is to reissue new bonds at lower interest rates (why should they pay more than the market rate!). As a result, the value of the callable bond will begin to deviate from that of the noncallable bond as rates continue to decline. This pattern of the price-yield relationship is referred to as negative convexity.

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Windknot Good stuff
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