Page 54 - PowerPoint Presentation

LOS 36.l: Compare effective convexities of
callable, putable, and straight bonds.
READING 36: VALUATION AND ANALYSIS: BONDS WITH EMBEDDED OPTIONS
MODULE 36.6: KEY RATE DURATION
Callable bonds: When rates are
high, they are unlikely to be called
and will exhibit positive
convexity. When the underlying
call option is near the money (at
lower yields), it turns negative
convexity; the upside potential of
the bond’s price is limited due to
the call price (while the downside is
not protected).
Putable bonds: At high yields (above Y*)
convexity is positive; the put option is likely to be
exercised: Why? Issuer is now higher risk and for
the already-fixed coupon payments, investor is
better-off selling (s/he has already made returns
via yield; or, finds it too risky and wants out)!