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

Which of the following statements about the value of a callable bond is NOT correct?

A) The value of a callable bond equals the value of the bond without the option plus the option value.

B) The value of the callable bond is less than the value of an option-free bond in an amount equal to the value of the call option.

C) When yields rise, the value of a callable bond may exhibit less of a price change than a noncallable bond.

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The value of the call option is subtracted from the value of the bond without the option because the option is of value to the issuer, not the holder.

As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt. Also, it is more likely that the bond will be called. The other choices are correct.

optiix

Which of the following statements about a callable bond is CORRECT?

A) Callable bonds follow the standard inverse relationship between interest rates and price.

B) A bondholder usually loses if a bond is called by being forced to reinvest the proceeds at a lower interest rate.

C) The call option on a bond trades separately from the bond itself.

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A bondholder will most likely lose if a bond is called because a bond is most likely to be called in a declining interest rate environment. The issuer will likely call the bond and replace it with lower cost (lower coupon debt). The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments.
In bond trading, the call option is bundled with the bond and is not traded separately. The price of a callable bond does not follow the standard inverse relationship. As yields fall, the call option becomes more valuable to the issuer. With a decrease in interest rates, the value of a callable bond can only increase to approximately the call value. Straight bonds will continue to exhibit the inverse relationship between yields and prices as there is no ceiling call price. When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature.

optiix

Which of the following is an incorrect statement when zero-coupon bonds are compared to coupon-paying bonds with the same maturity? Zero-coupon bonds:

A) have a higher duration.

B) are sold at a lower price.

C) are less sensitive to interest rate changes.

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Since zero-coupon bonds have a higher duration than coupon-paying bonds of the same maturity, they are more sensitive to interest rate changes.

optiix

If a portfolio manager anticipates a major increase in market interest rates, the most appropriate trading strategy is to purchase:

A) long-maturity bonds with low coupon rates.

B) short-maturity bonds with high coupon rates.

C) high yield bonds with high coupon rates.

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The price volatility of non-callable bonds is inversely related to the level of market yields. As yields increase, bond prices fall, and the price curve gets flatter. Bonds with higher duration will change more in price. Longer maturity bonds with lower coupon rates are more sensitive to interest rate risk and their price will decrease more than short term, high coupon rate bonds. High yield ("junk") bonds with high coupons become more risky in high interest rate environments and therefore would not be appropriate.

optiix

Which of the following statements about a bond with a call feature is least accurate? The call feature:

A) reduces the bond's capital appreciation potential.

B) exposes investors to additional reinvestment rate risk.

C) increases the bond's duration, increasing price risk.

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A call feature decreases a bond's duration.

clearlycanadian

What will happen to interest rate risk for an option-free bond if market yields decrease?

A) Interest rate risk will increase.

B) Interest rate risk will decrease.

C) Even if the term structure is flat, interest rate risk could go up or down based on the level of the term structure at the time market yields decrease.

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If market yields decrease, interest risk will increase since the duration or the sensitivity of the bond to interest rate fluctuation will increase.

clearlycanadian

Which of the following bond features would result in lower interest rate risk? A:

A) lower coupon rate.

B) higher yield to maturity.

C) longer maturity.

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A higher yield to maturity would result in a shorter duration and lower interest rate risk. A longer maturity and lower coupon rate would result in longer durations and higher interest rate risk.

clearlycanadian

Tom Wilkens is a portfolio manager and has a retiree as a client. The client would like to invest in bonds with low interest rate risk. Which bond should Tom choose for his client? The bond with a:

A) 10 year maturity and a yield to maturity of 8%.

B) 20 year maturity and a yield to maturity of 5%.

C) 10 year maturity and a yield to maturity of 5%.

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The shorter the bond’s maturity and the higher the yield to maturity, the shorter the duration and the lower the interest rate risk.

clearlycanadian

All else equal, the lower the bond’s yield to maturity, the:

A) shorter the duration and the lower the interest rate risk.

B) shorter the duration and the higher the interest rate risk.

C) longer the duration and the higher the interest rate risk.

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A lower yield to maturity would result in a longer duration and higher interest rate risk.