An investor is considering one of the newly issued 10 year AAA corporate bonds s
ID: 2761805 • Letter: A
Question
An investor is considering one of the newly issued 10 year AAA corporate bonds shown in the following table:
Description
Coupon
Price
Callable
Call Price
XYZ
6.00%
100
Non-callable
N/A
RST
6.20%
100
Currently Callable
102
A. Suppose that market interest rates decline by 100 basis points (1%). Contrast the effect of this decline on the price of each bond.
B. Should the investor prefer the RST bond to the XYZ bond when rates are expected to rise or to fall?
C. What would be the effect, if any, of an increase in the volatility of interest rates on the prices of each bond?
Description
Coupon
Price
Callable
Call Price
XYZ
6.00%
100
Non-callable
N/A
RST
6.20%
100
Currently Callable
102
Explanation / Answer
Answer:A The maturity of each bond is 10 years and we assume that coupons are paid semiannually. Since both bonds are selling at par value.the current YTM for each bond is equal to the coupon rate.
If the yield decrease by 1% to 5%(2.5% semiannual Yield), XYZ bond will increase in value to 107.79 (N=20,I=2.5%,FV=100,PMT=3)
The price of RST will also increase but only to the call price of 102.The Present value of scheduled payment is greater than 102 , but the calls price put a ceiling on the actual bond Price.
Answrer:B Investor would prefer the RST bond in either a rising or a stable interest rate scenario. The RST bond has an embedded option, which is sold by the investor to the issuer of the bond. The higher yield compensates investor for the risk of being short the embedded call option. If rates are stable or increase, the investor earns the extra income without having to worry about having the bond called from them. Additionally, if rates increase,RST bond price should decrease less relative to XYZ bond because of RST shorter effective duration due to the embedded call option.
Answer:C Since the XYZ bond is noncallable, increased interest rate volatility would not impact its directional price change.
(ii) Callable bond value = Non-callable bond value - Call option value
The level and volatility of interest rates are key factors in determining the value of a bond with an embedded call option. The greater the variance or uncertainty of interest rates, the greater the value of the embedded call option. As the embedded option value increases, it causes the value of RST's callable bond to decrease.
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