Explain the effect of interest rate volatility on what a callable or putable bond is worth
The idea
Option value rises with volatility, whoever owns the option. A callable bond equals a straight bond minus a call held by the issuer, so higher interest rate volatility raises the call's value and lowers the callable bond's price. A putable bond equals a straight bond plus a put held by the investor, so higher volatility raises the putable bond's price. The straight bond's value on a calibrated tree does not depend on volatility. The same reasoning covers capped floaters, which lose value as volatility rises, and floored floaters, which gain. A common slip is to get the direction for callables wrong by forgetting that the bondholder has sold the option.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Valuation and Analysis of Bonds with Embedded Options
- Explain bonds and other debt securities that contain embedded options
- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework
- Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares