Effect of volatility and the arbitrage free value, Financial Management

The volatility assumption has a great influence on the arbitrage free value of the bond. The higher the expected volatility, the greater the value of an option. When we assume a higher interest rate volatility for a callable bond, it means that the value of the call option increases. But the value of the option-free bond is not affected; therefore the value of the callable bond will be lower.

Let us consider that the binomial interest rate tree provides a value of $105.385 for both 10% and 20% interest rate volatility. The value of the callable bond with a volatility interest rate assumed at 20% and callable at par beginning in year-1 is $103.076 and the value of the callable bond with an assumed interest rate volatility of 10% is $103.765. We notice that the higher the assumed volatility, the lower the value of the callable bond. This is because the value of an option increases with the higher assumed volatility. Therefore, the value of the embedded option is higher at 20% assumed volatility than the value of the embedded option at 10%. When a higher value for the embedded call option is subtracted from the option-free value, the value of the callable bond would be lower compared to 10% volatility. The difference between the two values implies that the bond is cheaper by $0.689.

Posted Date: 9/10/2012 7:03:47 AM | Location : United States







Related Discussions:- Effect of volatility and the arbitrage free value, Assignment Help, Ask Question on Effect of volatility and the arbitrage free value, Get Answer, Expert's Help, Effect of volatility and the arbitrage free value Discussions

Write discussion on Effect of volatility and the arbitrage free value
Your posts are moderated
Related Questions
Types of financial incentive schemes Performance associated pay (PRP) systems e.g. piecework or sales commission Bonuses e.g. supplementary payments for targets or ai

This case has been framed in order to test the skills in evaluating a credit request and reaching a correct decision. Perluence International is large manufacturer

Performance budget: it involves evaluation of the performance of the organization in the context of both overall and specific objectives of the organization. As per the National I

Define the following terms that relate to a convertible bond:  conversion ratio, conversion value, and straight bond value. The term conversion ratio is the number of shares of c

A firm's operating and financing decisions   Risk also results from decisions made within the company.  This risk is usually divided into two classes:  - Business risk is th

Joe's ice cream stroe has to decide whether to shut down this winter or stay open. His projected revenue is $1,200 per week. He has fixed costs (Mortgage, taxes, insurance, etc.) t

A proposal to extend the ABC Gas Company Ltd's gas distribution network to the NOIDA industrial cluster, about 40 km east of Delhi, at distance of about 20 kms from the ABC's exist

Evergreen Company Ltd has been promoted by promoters. They are trying to decide how the company could be financed. There are three choices: i. Issue Rs 500,000 in Equity shares

Q. Explain about Types of costs? Thus two types of costs are involved in keeping cash balance in a business- (i) Opportunity Cost (ii) Transaction Cost When cash balan

Determine the Management buy-outs Management buy-outs (MBOs) The management of company buy out the shareholders. Management will usually require financial backers (ventu