Price-yield relationship of a callable bond, Financial Management

Price-Yield Relationship of a Callable Bond

The price-yield relationship of a non-callable or a non-puttable bond is convex because price and yield are inversely proportional. Figure 2 shows the price-yield relationship of a bond when it is callable and non-callable. The non-convex nature of a callable bond can be explained as follows.

From the definition of the callable bond, we know that a bond becomes callable only when the prevailing market yield is less than the coupon rate on comparable bonds. The price-yield curve of a bond is unaffected till the time it becomes callable. Investors may not be willing to pay the same price for a bond even when the coupon rate on the bond is just lower than the market yield as what would have been its price if it were a callable bond, for there is a possibility of a further drop in the market yield and the issuer may call the bond. As yields decline, there is an increasing possibility of the issuer calling the bond. Though the exact yield level at which the bond would be called may not be known, but the existence of such a level is certain. In Figure 2, for yield levels below y*, the price-yield relationship of a callable bond differs from that of a non-callable bond. For instance, the market yield is such that a bond would be selling for 107. But if it is a callable bond then it might be called at 105 and hence the investors will not be willing to pay 107. Even if the investors purchase at 107 and if the bond is called, then they get only 105 and hence there is a loss of 2 units per bond. For a range of yields below y*, there is price compression. Hereby price compression we mean that as yields decline price appreciation is limited. This portion of the price-yield relationship of a callable bond below y* is termed negatively convex because of the following reason. Increase in yields by a given number of basis points will result in a greater price decline compared to the price appreciation if yields decline by the same number of basis points.

1045_price yield relationship.png

Posted Date: 9/10/2012 8:11:58 AM | Location : United States







Related Discussions:- Price-yield relationship of a callable bond, Assignment Help, Ask Question on Price-yield relationship of a callable bond, Get Answer, Expert's Help, Price-yield relationship of a callable bond Discussions

Write discussion on Price-yield relationship of a callable bond
Your posts are moderated
Related Questions
Taxonomy of financial intermediaries We start by looking at the USA, the largest economy and financial system in the world. Subsequently we will turn to other countries. In the

Define the P/E valuation method. Under what circumstances should a stock be valued using this method? The P/E ratio specifies how much investors are willing to pay for each dol

Explain the significance of the term additional funds needed. While the pro forma balance sheet is completed, total assets and total liabilities and equity will hardly match.

Chi Square Test as a Test of Independence In real life decision making, managers often have to know whether the differences between the proportions observed from a number of sa

These are bonds which are offered within the euro market and several other markets simultaneously. Unlike Eurobonds, global bonds can be issued in the same curren

Banks find it essential to accommodate their client’s requirements to buy or sell foreign exchange forward, in many examples for hedging purposes.  How can the bank eliminate the c

State about the Audit plan contents 1. Report requirements and terms of reference. 2. A review of business and financial position, reviewing why changes had occurred in curr

To what extent does empirical evidence on corporate objectives support the predictions of Baumol’s “Sales Maximisation Hypothesis?”

Treasury Bills, popularly known as T-bills, are issued in India by the RBI on behalf of the Government of India. T-bills are short-term securities with a maturity of 91

dear, I found an exercise on the Internet which could help me has better to understand the finance, but there were no answers. What is that you can help me has to solve it. I''m fr