optiix

When market rates were 6% an analyst observed a $1,000 par value callable bond selling for $950. At the same time the analyst also observed an identical non-callable bond selling for $980. What would the analyst estimate the value of the call option on the callable bond to be worth?

A) $20.

B) $80.

C) $30.

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The noncallable bond has the traditional PY shape. The callable bond bends backwards. The difference between the two curves is the value of the option. 980 − 950 = $30.

optiix

If the volatility of interest rates increases, which of the following will experience the smallest price increase resulting from lower rates?

A) Callable bond.

B) Putable bond.

C) Zero-coupon option-free bond.

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For a callable bond the issuer has the option to call the bond if the interest rate decreases during its call period. The issuer will call the bond if interest rates have decreased in order to obtain cheaper financing elsewhere. If the interest rate volatility increases the chance the it is optimal for the issuer to call the bond increases, making the call option more valuable. Therefore, the bond price is depressed by an increase in interest rate volatility.

optiix

As part of his job at an investment banking firm, Damian O’Connor, CFA, needs to calculate the value of bonds that contain a call option. Today, he must value a 10-year, 7.5% annual coupon bond callable in five years priced at 96.5 (prices are stated as a percentage of par). A straight bond that is similar in all other aspects as the callable bond is priced at 99.0. Which of the following is closest to the value of the call option?

A) 2.5.

B) 4.2.

C) 3.5.

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To calculate the option value, rearrange the formula for a callable bond to look like:

Value of embedded call option = Value of straight bond – Callable bond value
Value of call option = 99.0 – 96.5 = 2.5.

Remember: The call option is of value to the issuer, not the holder.

optiix

Which of the following statements about the relationship between the value of a callable bond, the value of an option-free bond, and the value of the embedded call option is CORRECT?

A) Value of a callable bond = present value of the interest payments + present value of the principal at maturity.

B) Value of a callable bond = value of an option-free bond − value of an embedded call option.

C) Value of a callable bond = value of an option-free bond + value of an embedded call option.

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Because the bondholder has given something of value to the issue of a callable bond, the value of the embedded call option should be subtracted from the value of the straight bond.

optiix

Jori England, CFA candidate, is studying the value of callable bonds. She has the following information: a callable bond with a call option value calculated at 1.75 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 98.0. Which of the following choices is closest to what England calculates as the value for the callable bond?

A) 99.75.

B) 98.75.

C) 96.25.

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To calculate the callable bond value, use the following formula:

Value of callable bond = Value of straight bond – Call option value
Value of callable bond = 98.0 – 1.75 = 96.25.

Remember: The call option is of value to the issuer, not the holder.

optiix

Which of the following statements about embedded call options is most accurate?

A) The call price acts as a floor on the value of a callable bond.

B) When yields rise, the value of a callable bond may not fall as much as a similar, straight bond.

C) The value of a callable bond is equal to the value of the straight bond component plus the value of the embedded call option.

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The value of a callable bond is equal to the value of the straight bond component minus the value of the embedded call option. Remember, the call option benefits the issuer, not the investor. The call price acts as a ceiling on the value of a callable bond. The value of a callable bond will always be equal to or less than an otherwise identical non-callable bond.

optiix

Which of the following is least likely to be given as a reason that the prices of floating-rate bonds fluctuate from par?

A) Coupon formulas with fixed-rate margins.

B) Cap risk.

C) Call risk.

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Call risk pertains to callable bonds and is the risk of the bond issuer "calling the bond" when interest rates decrease. The issuer replaces the current bond with lower interest rate debt but the current bond holder usually loses due to having to replace their bond with a lower paying coupon bond. This has nothing to do with floating rate bonds. The rest of the choices are reasons why floating rate bonds fluctuate from par.
With a cap, when the market yield is above its capped coupon rate, a floating-rate security will trade at a discount.  With fixed rate margins, if the creditworthiness of the firm improves, the floater is less risky and will trade at a premium to par.

optiix

Which of the following statements is NOT correct? All else equal, a floating-rate bond with:

A) coupon reset dates every 3 months will have more price fluctuation than a bond with reset dates every 6 months.

B) a fixed-margin rate in the coupon formula will experience greater price fluctuation than a bond with an adjustable margin rate.

C) an interest rate cap will have more price fluctuation than a bond with no interest rate cap.

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The more frequent the reset dates, the less the time lag that causes volatility. The greater the gap between reset dates, the greater the amount of price fluctuation.
Over the life of a bond, the required market margin is not constant. A fixed-margin coupon exposes the bond to more price fluctuations than an adjustable margin (as is the case with an extendible reset bond). Cap risk refers to when market interest rates rise to the point that the coupon on a floating-rate security hits the cap and the bond begins to behave like a fixed coupon bond, which has more price fluctuations.

optiix

The risk to a holder of a floating-rate bond that market rates will increase to the point where the bond behaves like a fixed-rate bond (increased price fluctuation) is known as:

A) inflation risk.

B) yield curve risk.

C) cap risk.

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This is the correct definition of cap risk. Cap risk occurs with floating-rate bonds that have a cap placed on how high the coupon rate can go.
Inflation risk refers to the risk that the rate of inflation will be higher than the investor anticipated, resulting in reduced purchasing power. An investor can reduce exposure to inflation risk by holding floating-rate bonds.

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Which of the following statements about floating-rate bonds is NOT correct?

A) Holding a floating-rate bond eliminates price fluctuations.

B) With a perfect, continuously resetting coupon rate, a floating-rate bond's value would always equal par.

C) A cap rate can increase the price volatility of a floating-rate bond.

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Holding floating-rate bonds minimizes, but does not eliminate price fluctuations. The other statements are true.