***Embedded Options when interest rates rise***

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robe_ch

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Hi all,

Some questions regarding embedded options basic.

If interest rates decline, the price of an callable bond will not increase as much as a option free bond, due to the fact that: Price of callable bond = Price of an similar option free bond - price of embedded options.
Make sense.... but,
if interest rates rise, the price of a callable bond will not fall as much as an otherwise option - free bond, that's the question, why is this the case??

Formula is still the same, and if interest rise, bond price will fall, and embedded option price also will fall, but have still value, so we have to deduct it from the price of an similar option free bond, so why it will not fall as much as an otherwise option free bond????

thanks a lot for your help!!!
 
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To ChadD. No, the other discussion was about increase in interest rate volatility (without increase in interest rates themselves).
 
I apologise if I have misunderstood the question - but from what I can gather , the answer is rather trivial

100 -2 =98 - >bond with embedded option

if we ignore non linear terms, a 2% change in option free bond : = 2 $ increase or decrease. while a 2% increase or decrease in 98 is 1.96 $ which is <2 $.

perhaps, the increase or decrease should be viewed in terms of absolute numbers and not %ges?.

again, please ignore this if I am not answering the question that is being asked.
 
The original question of rob_ch seems to be more that he/she is questioning why the
situation is symmetrical, i.e., the option free both declines/increases more than does the
callable bond for a change in interest rate.

If you understand that one has a greater duration than the other then you don't have to do much more thinking: duration is used to estimate changes of price for a change in interest rate in either direction. [Don't forget convexity though, since the magnitude in one direction is not quite what it is in the other direction.]

But it is good to be puzzled over these things--eventually you sort it out and reach a deeper understanding.
 
I think it depends on where the bond is on the yield curve. The change in price will move differently if the bond is very close to it's call price verses at a low price that is far from the call price, in which case it will behave very similarly to a non-callable bond.
 
absolute clear for interest rate fall's, but why it is for interest rates rise, if interest rates rise, price of bond goes down (assumption in a linear way) means that:

price of call. bond = Price of similar non call. bond - price of embedded option

CFAI readings says: "if interest rates rise, the price of a callable bond will not fall as much as an otherwise option - free bond...." sounds strange for me, because, the formula says minus price of embedded option, so the price should fall more as for an option free bond isn't id??
 
robe_ch,

why are you assuming that the option cost remains constant? . please explain with some numbers what your thought process is...

thanks



Edited 1 time(s). Last edit at Friday, July 20, 2007 at 04:38AM by Dsylexic.
 
(hyp. price) 102.80 means 103 for similar non call. bond - 0.20 for the embedd. option.

if interest rice, price will come down. ass. linear, so

(hyp. price) 101.80 means 101.95 for a similar non call bond - 0.15 for the embedd. option.

so fall of an option free bond 103/101.95 = 1.02% diff.

call bond 102.80/101.80 = 0.97% diff.

is this what they mean with "if interest rates rise, the price of a callable bond will not fall as much as an otherwise option - free bond...."???
 
lillie Wrote:
-------------------------------------------------------
> The original question of rob_ch seems to be more
> that he/she is questioning why the
> situation is symmetrical, i.e., the option free
> both declines/increases more than does the
> callable bond for a change in interest rate.
>
> If you understand that one has a greater duration
> than the other then you don't have to do much more
> thinking: duration is used to estimate changes of
> price for a change in interest rate in either
> direction.
>

I get chills. Good job lillie. Are you an L1 candidate?


> But it is good to be puzzled over these
> things--eventually you sort it out and reach a
> deeper understanding.
 
The answer to your question lies in fact that embedded call option decreases when interest rates rise more than price of an option-free bond. This of course affects duration of an option-embedded bond.
 
JoeyDVivre Wrote:
-------------------------------------------------------

>
> I get chills. Good job lillie. Are you an L1
> candidate?
>
>


Joey's already picking out teacher's pets for the December exam!!!



There have already been many good explanations here, so I will offer this one, which is far from the best. In fact, it's not an explanation at all... just a way to remember this and get the question right on the exam!

I always refer back to the Price / Yield diagram of a callable vs. non-call bond on page 617 of the CFAI text. In this case, you might remember, the callable bond price rises less quickly than the option free bond, as yields fall. It just makes no sense how the price could NOT fall less quickly therefore. I mean... there's only one line representing the relationship and it's going to hold true regardless of what previous state your bond was in.

Again.. not an explanation, just a solution.

Despite the constant admonitions to understand the material, I happen to think it's pretty important to answer the questions correctly, too!
 
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