Page 46 - PowerPoint Presentation

LOS 36.d: Explain how interest rate READING 36: VALUATION AND ANALYSIS: BONDS WITH EMBEDDED OPTIONS
volatility affects the value of a callable or
putable bond.
MODULE 36.3: VALUING BONDS WITH EMBEDDED OPTIONS, PART 2

The higher the interest rate volatility (risk), the higher the values of embedded call and put options.
• Higher interest rate volatility = lower value of a callable bond (where the investor is short the call option);
= higher value of a putable bond (where the investor is long the put option).
For a straight bond, value is affected by changes in level of interest rates (capital gains) but not by changes interest rate volatility.

LOS 36.e: Explain how changes in the level and shape of the yield curve affect the value of a callable or putable bond.

Level of Interest Rates: The inverse (negative) relationship between interest rates and bond prices is well established: Why?
1. Increased (higher) interest rates means higher discount rates which reduces present values of bond cash inflows; or
2. Investors locked in fixed interest annuity receipts may wish to sell bonds and shift funds towards new debt instruments that
pay the increased interest rates. And vice versa!
Implication for value of call option value?
Inverse relationship: Higher interest (discount) rate = lower the bonds value (< par). Why call (buy-back) pay higher par? Issuer
is unlikely to call, hence lower call option value! (note: call feature limits the upside potential or probability of the call being ‘in-
the-money’). The opposite is true for lower interest rate!

Though the higher interest rates means lower call option value, the value of callable bond rises, but less rapidly than the value of
an otherwise-equivalent straight bond.

Implication for value of call option value?
Direct relationship: Higher the interest (discount) rate = lower the bonds value (< par): Why not put (sell) and receive higher par?
Investor is likely to put, hence higher put option value! (note: put feature sweetens the bond and increases upside potential for
the investor or increases the probability it being ‘in-the-money’). The opposite is true for lower interest rate!

Though the higher interest rates means higher put option value, the value of putable bond falls less rapidly less rapidly than the
value of an otherwise-equivalent straight bond.