Kingpin804

An analyst is evaluating the following two statements about putable bonds:

Statement #1: As yields fall, the price of putable bonds will rise less quickly than similar option-free bonds (beyond a critical point) due to the decrease in value of the embedded put option.
Statement #2: As yields rise, the price of putable bonds will fall more quickly than similar option-free bonds (beyond a critical point) due to the increase in value of the embedded put option.

The analyst should:

A) disagree with both statements.

B) agree with both statements.

C) agree with only one statement.

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Both statements are false. As yields fall, the value of the embedded put option in a putable bond decreases and (beyond a critical point) the putable bond behaves much the same as an option-free bond. As yields rise, the value of the embedded put option increases and (beyond a critical point) the putable bond decreases in value less quickly than a similar option-free bond.

Kingpin804

At a market rate of 7%, a $1,000 callable par value bond is priced at $910, while a similar bond that is non-callable is priced at $960. What is the value of the embedded call option?

A) $40.

B) $50.

C) $30.

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The value of the embedded call option is simply stated as:  
value of the straight bond component – callable bond value = value of embedded call option.
$960 – $910 = $50

Kingpin804

Which of the following statements best describes the concept of negative convexity in bond prices? As interest rates:

A) fall, the bond's price increases at an increasing rate.

B) rise, the bond's price decreases at a decreasing rate.

C) fall, the bond's price increases at a decreasing rate.

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Negative convexity occurs with bonds that have prepayment/call features. As interest rates fall, the borrower/issuer is more likely to repay/call the bond, which causes the bond’s price to approach a maximum. As such, the bond’s price increases at a decreasing rate as interest rates decrease.