Reading 57: LOS e ～ Q1- 5

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

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

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

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

The correct answer was D)

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.

2.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)   Embedded call, zero, callable bond, option-free bond.

B)   Zero, embedded call, option-free bond, callable bond.

C)   Embedded call, callable bond, zero, option-free bond.

D)   Zero, embedded call, callable bond, option-free bond.

The correct answer was D)

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.

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

A)   decreases.

B)   increases.

C)   remains the same.

D)   increases or decreases.

The correct answer was A)

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.

4.The value of a callable bond is equal to the:

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

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

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

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

The correct answer was D)

The value of a bond with an embedded call option is simply the value of a noncallable (V_noncallable) bond minus the value of the option (V_call). That is: V_callable = V_noncallable – V_call.