burning0spear

Which of the following statements about embedded options and yield volatility is NOT correct?

A) As yield volatility increases, the value of the call option increases along with the value of the callable bond.

B) Putable bondholders benefit from increases in yield volatility.

C) A call option benefits the issuer and a put option benefits the holder.

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As yield volatility increases, the value of the call option increases, and the value of the callable bond decreases and thus the bondholder loses. (As shown by the equation: Value of callable bond = Value of straight bond – Call option value.) The other choices are true. A holder of a put option benefits from increased yield volatility because the value of the put option increases, increasing the putable bond value. (Value of putable bond = Value of straight bond + Put option value.)

burning0spear

Which of the following statements concerning the effects of interest rate volatility on bonds with embedded options is least accurate?

A) A putable bond's value is its straight bond value plus the value of the embedded put option.

B) As yield volatility increases, the value of callable bonds decreases.

C) A callable bond's value is its straight bond value plus the value of the embedded call option.

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A callable bond’s value is its straight bond value minus the value of the embedded call option. Since the bondholder is effectively short a call option, the value of the option is subtracted from the bond price. This is why the value of callable bonds decreases when yield volatility rises.

burning0spear

Which of the following statements is CORRECT for both callable and putable bonds?

A) When yield volatility increases, the value of the option increases.

B) The value of the bond is equal to the value of a similar straight bond plus the value of the option.

C) When yield volatility increases, the value of the bond increases.

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To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases.

burning0spear

Tina Donaldson, CFA candidate, is studying yield volatility and the value of putable bonds. She has the following information: a putable bond with a put option value calculated at 0.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 99.0. Donaldson also wants to determine how the bond’s value will change if yield volatility decreases. Which of the following choices is closest to what Donaldson calculates as the value for the putable bond and correctly describes the bond’s price behavior as yield volatility decreases?

A) 99.75, price increases.

B) 99.75, price decreases.

C) 98.25, price decreases.

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To calculate the putable bond value, use the following formula:
Value of putable bond = Value of straight bond + Put option value
Value of putable bond = 99.0 + 0.75 = 99.75.
Remember: The put option is added to the bond value because the put option is of value to the bondholder, not the issuer.
As yield volatility decreases, the value of the embedded option decreases. The formula above shows that for a putable bond, a decrease in the option value results in a decreased bond value.

burning0spear

Which of the following is NOT an example of event risk?

A) A corporation calls a large bond issue.

B) Ratings agencies downgrade a company's rating after the company takes on a significant amount of debt to fund a leveraged buy-out (LBO).

C) An interim South American government imposes restrictions on the outflow of capital.

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A corporation calling a large bond issue is an example of call risk.
The other choices are examples of types of event risk, which includes disaster/accident, corporate, regulatory, and political risks. Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The South American government’s actions are an example of political event risk. The LBO-related rating downgrade is an example of corporate event risk.

burning0spear

Kira Sigard, CFA and an attorney with an investment banking firm, structures a client’s bond issue to include a “poison put.” This is a provision that requires the issuer to redeem the bond at par in the case of a corporate takeover, a merger, or anti-takeover measure that would dissipate significant corporate assets. An investor who purchases this bond is protected from what type of risk?

A) Event Risk.

B) Liquidity Risk.

C) Call Risk.

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Event risk refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation. The poison put specifically protects an investor from corporate event risk.
Call Risk, or prepayment risk, is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Liquidity risk addresses how quickly and easily an investor can sell a bond.

burning0spear

Which of the following circumstances is an example of event risk?

A) The U.S. Federal Reserve unexpectedly increases interest rates by 100 basis points.

B) A bond's bid/ask spread widens.

C) A local government regulatory agency introduces more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill.

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A local government regulatory agency introducing more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill is an example of regulatory risk, which is a type of event risk. The impact of regulatory risk can be long-term, in that the company may be unable to pass on the increased cost to customers.
The other choices are examples of other types of risk that bondholders face. A widening bid-ask spread indicates increased liquidity risk. The Federal Reserve’s action is an example of interest rate risk.

burning0spear

All of the following risks are types of event risk EXCEPT:

A) interest rate risk.

B) disaster/accident risk.

C) political risk.

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Interest rate risk is the risk that interest rates will increase, decreasing the price of certain investments, including fixed-coupon bonds.
The other choices are examples of event risk, which refers to the possibility that there may be a single event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation.

terpsichorefan

thanks for sharing

adorend

好人一生平安~~