dkishore1

How is the value of the embedded call option of a callable bond determined? The value of the embedded call option is:

A) the difference between the value of the option-free bond and the callable bond.

B) equal to the amount by which the callable bond value exceeds the option-free bond value.

C) determined using the standard Black-Scholes model.

---

The callable bond is equivalent to the option-free bond except that the issuer has the option to call the bond at the call price before maturity. Therefore, for the holder of the bond, the bond is worth the same as the option-free bond reduced by the value of the option.

dkishore1

Which of the following is equal to the value of the putable bond? The putable bond value is equal to the:

A) option-free bond value minus the value of the put option.

B) callable bond plus the value of the put option.

C) option-free bond value plus the value of the put option.

---

The value of a putable bond can be expressed as Vputable = Vnonputable + Vput.

dkishore1

The value of a callable bond is equal to the:

A) option-free bond value minus the value of the call option.

B) callable bond value minus the value of the put option minus the value of the call option.

C) callable bond plus the value of the embedded call option.

---

The value of a bond with an embedded call option is simply the value of a noncallable (Vnoncallable) bond minus the value of the option (Vcall). That is: Vcallable = Vnoncallable – Vcall.

dkishore1

How does the value of a callable bond compare to a noncallable bond? The bond value is:

A) lower.

B) lower or higher.

C) higher.

---

Since the issuer has the option to call the bonds before maturity, he is able to call the bonds when their coupon rate is high relative to the market interest rate and obtain cheaper financing through a new bond issue. This, however, is not in the interest of the bond holders who would like to continue receiving the high coupon rates. Therefore, they will only pay a lower price for callable bonds.

dkishore1

A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

A) $0, embedded call, callable bond, option-free bond.

B) Embedded call, callable bond, $0, option-free bond.

C) Embedded call, $0, callable bond, option-free bond.

---

The embedded call will always have a positive value prior to expiration, and this is especially true if the callable bond trades at par value. Since investors must be compensated for the call feature, the value of the option-free bond must exceed that of a callable bond with the same coupon and maturity and rating.

dkishore1

A callable bond, a putable bond, and an option-free bond have the same coupon, maturity and rating. The call price and put price are 98 and 102 respectively. The option-free bond trades at par. Which of the following lists correctly orders the values of the three bonds from lowest to highest?

A) Callable bond, option-free bond, putable bond.

B) Option-free bond, putable bond, callable bond.

C) Putable bond, option-free bond, callable bond.

---

The put feature increases the value of a bond and the call feature lowers the value of a bond, when all other things are equal. Thus, the putable bond generally trades higher than a corresponding option-free bond, and the callable bond trades at a lower price.

dkishore1

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.

---

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.

dkishore1

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 fell.

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

---

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

dkishore1

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.

---

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.

dkishore1

Which part of the nominal spread does the option-adjusted spread (OAS) capture?

A) credit and liquidity risk.

B) interest rate and volatility risk.

C) option risk.

---

The OAS removes the amount that is due to option risk from the nominal spread leaving just the credit and liquidity risk.