Bond Confusion

[Olga D]

hello all ..there is this Q that seems to be confusing me from the schweser notes and i was wondering if any of you could be able to throw in some help' Suppose that the volatility of interest rates increases. Which of the following will experience the largest price decrease?
A. a callable bond
B. a putable bond
C. an option-free coupon bond
D. a zero-coupon option free bondThe answer they have given is A. a callable bondwhile i understand why that could be true i dont see why D is not correct. I mean zero coupon bonds are the most sensitive to changes in interest rates because they receive all their cash flows at the maturity. Or when they mention volatility are they talking of something other than just interest rates.

 

[FinPrep]

The key to this is the word volatility. The value of an option increases with volatility. That is, the higher the volatility, the higher the option value. Hence the two option-free bonds will not change in value if (expected) volatility increases. The putable bond will increase in value because this is an option granted by the issuer to the bond holder. The callable bond will decrease in value because the call option is granted by the bondholder to the issuer.Hope that helps.

 

[Beantown Boy]

Remember that the question doesn't indicate whether interest rates were going up or down, they're just volatile. Thus, callable bonds would be worth less.

 

[Wrally]

Intuitively you might be correct, however the real market is different.A zero does not have immediate reinvestment risk, that is there isn't any current income that needs to be reinvested (remember coupon is assumed to be reinvested at the same rate until maturity). As interest rates move, the price of a callable bond, or any other bond that is paying income is subject to this reinvestment risk. So as rates move lower, you reinvest the coupons at a lower rate, and the issuer, seeing rates trending lower, is more likely to call the bond.I hope this helps. Anyone else care to jump in?

 

[help]

Here is a callable bond position frm an investors point of view : portfolio value = long one bond + ( - short a call option). As volatility increses, the option's value will increase. Note, because you are short the call, your are worse off as it increses in value with the increase in volatility. Therefore, as the call increases in value, your portfolio of long bond short call decreases. The zero only has price risk if you intend to sell prior to maturity. If you do not plan to sell the zero early, the changes in rates will have no effect.

 

[Olga D]

Thank you very much finprep,beantownboy,wrally and help. I do understand it very well now .