Prepayment option vs put option decrease, interest, understand, language

andytrader

If there was an effect that decreases interest rate yield volatility on the market yield of two debt security with A) prepayment option and B) put option, how are they affected?

I understand A will decrease, but what about B? Can someone put it to me in simple language.

Bulla564

It's just a fancy way of saying when the bond price goes up the yield on the bond goes down.

btw - "Value of putable bond equals the value of an option-free bond plus the value of the put option." is only true if either
a: It's circular so the value of the put option is just the value of the bond minus the option free bond; or,

b) There's a ton of assumptions there. For instance, if the bond is puttable back to the issuer then the credit risk of the put is probably much bigger than the credit risk of the bond, i.e., the issuer misses an interest payment so you try to put the bond back to him. If he can't pay the coupon, it's really unlikely he can buy the bond back at the put price (say, par). You would much rather own a credit risky bond + put on that bond from JDV Investments or Goldman Sachs or someone than a puttable bond.

Maddin

Hi beaththecfa,

I understand everything about your post apart from the very end. Can you please further explain the following:

why is a fall in the value of a putable bond equivalent to an increase in its market yield?

thanks

hariRaj

OK! Look at it from an investor's point of view.

Value of putable bond equals the value of an option-free bond plus the value of the put option.

A decrease in interest rate volatility reduces the value of the put option and therefore, the value of the putable bond falls. A fall in the value of the putable bond is equivalent to an increase in its market yield.


Value of prepayable (callable) bond equals the value of the option-free bond minus the value of the call option. (the investor is long on the option-free bond but short on the call option).

A decrease in interest rate volatility reduces the value of the call option and therefore, the value of the prepayable bond rises. A rise in the value of the prepayable bond is equivalent to a decrease in its market yield.

cchang

Of course. The question goes like this:

The effects of a decrease in interest rate(yield) volatility on the market yields of a debt security with a prepayment option an don a debt security with a put option are most likely a(n):

Prepayments option: increase/decrease
Put option: increase/decrease

and you have to choose which one increases or decreases.

Thanks

disiz64

The prepayment option is like a call option. It is held by the issuer of the bond (or homeowner in the case of a mortgage loan).

A decrease in interest rate volatility decreases the value of both calls and puts.

Why don't you post the question properly. I don't understand whether you are asking for the effect on the value of the bond, or on the value of just the option embedded int the bond, or on the yield on the bond. Please clarify.

invic

a decrease in volatility would decrease the value of a put.


think of it this way. an investor WANTS to exercise the put option. and an increase of volatility increases that chance. a decrease in volatiltiy has the opposite affect