LOS f: Explain the effect of volatility on the arbitrage-free value of an option.

Q1. As the volatility of interest rates increases, the value of a callable bond will:

A)   rise.

B)   rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

C)   decline.

Q2. On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

A)   The only possible explanation is that level of interest rates fell.

B)   A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose.

C)   A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell.

Q3. As the volatility of interest rates increases, the value of a putable bond will:

A)   rise.

B)   decline.

C)   rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

LOS f: Explain the effect of volatility on the arbitrage-free value of an option. fficeffice" />

Q1. As the volatility of interest rates increases, the value of a callable bond will:

A)   rise.

B)   rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

C)   decline.

Correct answer is C)

As volatility increases, so will the option value, which means the value of a callable bond will decline. Remember that with a callable bond, the investor is short the call option.

Q2. On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

A)   The only possible explanation is that level of interest rates fell.

B)   A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose.

C)   A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell.

Correct answer is C)

As volatility declines, so will the option value, which means the value of a callable bond will rise.

Q3. As the volatility of interest rates increases, the value of a putable bond will:

A)   rise.

B)   decline.

C)   rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

Correct answer is A)

As volatility increases, so will the option value, which means the value of a putable bond will rise. Remember that with a putable bond, the investor is long the put option.

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