Confirmation of interest rate volatility vs. changes therefore, directly, into, interest

rohitdoshi

Hi guys,

I studied Reading 54 today and jotted down some very brief notes. I'd like to put it into my book but just want to ensure it's accurate (because it's based on my deductions rather then being directly stated). Can someone please confirm and let me know if all is correct? Thank you!



Interest rate VOLATILITY up = Vcall up, Vnoncallable unaffected, therefore Vcallable down

While NONcallable bonds are not affected by interest rate volatility, they ARE affected by interest rate changes (inverse relationship).

Therefore, as interest rates go up, Vcallable down, Vcall down, Vnoncallable down.

tobeornottobe

In the question, it is the embedded call that is referenced. The embedded call has an inverse relationship with rates.


Wall now turns his attention to the value of the embedded call option. How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call:

A) decreases.

B) increases.

C) remains the same.


Your answer: A was correct!

Since the underlying asset to the option (the bond) decreases in value the option must decrease in value also. (Study Session 14, LOS 54.e, f)



Edited 1 time(s). Last edit at Tuesday, May 4, 2010 at 12:00PM by tenten.

luda002

I figured it out!

Peter Frampton, CFA @ Analyst Forum

oh yeah, I feel like you do!

bdavi77962

rus1bus Wrote:
-------------------------------------------------------
> Level 1 does not say anything about Value of
> Embedded Call Option changing with Interest Rates.
> And i think, establishing a relationship between
> them is not relevant either.
>
> It only talks about Value of Embedded Call Option
> changing with Interest Rate Volatility.

it is part of LEVEL 1

see Level 1 CFAI book 5 page 24
"
...when int rates decline ... the price of call option ...increases because the call option becomes more valuable to the issuer.

similarly, when int rates rise,... the price of embedded call option declines."

sameeragarwal

ataf, what you are quoting is value of free call option with interest rate changes. There is no argument on that, it will go down as interest rates go up.

What we are discussing is value of Embedded call option with interest rate changes.

Can you quote a relationship between value of Embedded call option with changes in Interest Rates in L1 text?

Rasec

Ok, so I found an "unofficial" answer to this:

For calls on Bonds the Delta drowns out the Rho effect - So pfcfaaf's reasoning is true.
The graph in the book is for equity securities, though it doesn't mention that in the book. In fact I don't remember reading anything on the differences b/w eq/bond options; does anyone have any reference to this in the CFAI texts? or would this not be tested? Iwould think that if there's a prectice Q like the one above it may be tested after all.


TenTen - BTW both answers are correct b/c for an equity call an increase in int rates would still increase the value of the equity call, however as was just posted with a rise in int rates the value of a call on a bond decreases.

troymo

So the answers conflict?!

Derivatives section tells us that as rates increase, rho causes the value of the call (and put) to increase slightly.

Fixed Income section tells us that as rates increase, the Value of the callable bond decreases and consequently, the value of the call on that bond decreases. As Schweser says in their answer:

Since the underlying asset to the option (the bond) decreases in value the option must decrease in value also. (Study Session 14, LOS 54.e, f)


Can someone please make sense of this conflict?

bolligerallstar

i dont have level 1 textbooks with me. what does it say about this?

liquidity

C=S+P-x/(1+r)

as r increases x decreases and C increases...

ok?

ayodayo

and what happens with S in the formula? (it changes with rate change too!)

pls see my second post in this thread, I was explaining rate change effect on parity (of bond option) there.



Edited 1 time(s). Last edit at Monday, May 3, 2010 at 02:54PM by pfcfaataf.