Bond with call and prepay options, Financial Management

Let us consider a bond with callable or prepayable feature. Figure shows the price/yield relationship of option-free bond and callable bond. The price yield relationship of option-free bond is represented by the convex curve a - a'. The price yield relationship of the callable bond is represented by the unusual curve a -b.

When market yield for comparable bonds is higher than the coupon rate on the callable bond then issuer will not call the bond. For example, if the coupon rate on a bond is 8% and the prevailing market yield on comparable bond is 13%, then undoubtedly issuer will not call the bond. Because the issuer of the bond is unlikely to call it, the price/yield relationship of callable bond is equal to the option-free bond. Therefore, the callable bond is valued as an option free bond. However call option still has some value, so the bond is not exactly priced like an option free bond.

If yield decreases in the market then there is a chance that issuer will call the bond. It is not necessary that issuer exercise the call option as market yield drops below the coupon rate. However, as yield approaches the coupon rate from higher yield level, the value of the embedded option increases. For example, assume that yield decreases from 13% to 8.75%; then it is most likely that issuer will not exercise the call option. But the issuer would probably exercise his right to call if the market yield declines further. The call option becomes more valuable to the issuer in this circumstance, thus reducing the price of the callable bond when compared to that of a comparable option-free bond. In figure 5, the value of the embedded call option at a given yield can be measured by the difference between the price of an option-free bond and the price on the curve a - b. We can also notice that at low yield levels, the value of the embedded call option is high.

Let us see how the price volatility property of a callable bond is different from that of an option-free bond. Figure 6 magnifies the portion of the price/yield relationship for the callable bond where the two curves in the figure depart. (Segment b - b' in figure ). As per property 4, when there is a large change in yield of a given number of basis points, the price of an option-free bond increases more than it decreases. But in case of a callable bond, the opposite is true i.e. for a given large change in the yield, the price of the bond appreciation is less than the price decline.

Let us look into the price volatility characteristic of a callable bond. From figure 1 it is clear that the curve has a concave shape. In financial terms, this is referred to as negative convexity. This characteristic of callable bond is not exhibited at every yield level.

When yield is high (in comparison to coupon rate), the bond shows same price/yield relationship as an option-free bond; and therefore at this level the gain is greater than the loss. The price/yield relationship of a option-free bond is referred to as positive convexity. Therefore, for a callable bond, we see negative convexity character at low yield levels and positive convexity character at high yield levels. This is illustrated in figure 2.

Figure 1: Negative Convexity Region of the Price/Yield Relationship for a Callable bond

1555_negative convexity.png

Figure 2: Negative and Positive Convexity Exhibited by Callable bond

1114_negative convexity1.png

We see in Figure 7 that at certain yield levels, when rates decline there is very little price appreciation. A bond is said to exhibit "price compression," when it enters this region.

Posted Date: 9/10/2012 4:19:50 AM | Location : United States







Related Discussions:- Bond with call and prepay options, Assignment Help, Ask Question on Bond with call and prepay options, Get Answer, Expert's Help, Bond with call and prepay options Discussions

Write discussion on Bond with call and prepay options
Your posts are moderated
Related Questions
why is agency problem important

The so-called "cash flow" (net income plus depreciation) is a flow of cash, but is it a flow to the shareholders or to the company? Suppose that net income plus depreciation is

Remaining differences with US GAAP IFRS 8 comprise intangible assets as part of the non-current assets. SFAS 131 only refers to tangible assets. IFRS 8 requires method

Imagine you have been allocated $100,000 which is to be invested in 8 companies listed on the Australian Stock Exchange (ASX). You are required to have a balanced portfolio betwee


Short sales  : Short sales of a security means borrowing of an underlying security by an investor from other investors who are holding it (in Demat account) and selling it with

INSTRUCTIONS Download the 2011 Annual Report for Marks and Spencer PLC, from the link provided on Study Space. Review the Annual Report, paying particular attention to the Fin

91-Day T-Bills Starting from July, 1965, 91-day T-bills were issued at a discount rate ranging from 2.5-4.6 percent per annum. Till July, 1974, the discount rate was 4.6 percen

Assume today is 3 December 2009. Helen is 30 years old and has a Bachelor of Business. She is currently employed as a personal banker for ANZ banking group in Sydney and earns $380

What is Performance appraisal - cost of capital Performance appraisal further, cost of capital framework can be used to evaluate financial performance of top management. I