Q4. I don’t quite get this. Don’t know where to start.
In the absence of a mention of ‘from upward/downward’ sloping, what should one construe of a ‘flat curve’? (In context of options)
Should one consider the 0-1 year maturity changes in the question or the fall in 2 year maturity…
Start with the wording of the scenario and the term of the bonds.
Scenario: rates in 2 year+ maturity fall.
Term of bonds: Bonds are three years to maturity. They will have most exposure to the three year rate.
Straight bond will rise in price.
Then consider options:
As yield curve flattens, forward rates in the tree fall. So the call option gains value (more likely to be called if rates fall as bond price rises), your put option loses value (similar reasoning).
Callable bond = straight - call option value (as it is benefiting the issuer): call option acts as a dampener on price rise
Putable bond = straight + put option value (as it benefits holder): put option acts as a dampener on price rise.
Thanks a lot.
So, in a ‘flat’ yield curve the features of the option will overplay (according to changes in interest rate volatility) while in a ‘flattening’ yield curve, those of the straight will. (Given the IRV assumptions I.e)
Rather than option value dominating the straight value in a ‘flat’ YC environment, I would say it is more accurate to say the option value dominates the straight value in a scenario where the level of YC does not change. In general though you should think of option value as much smaller than the bond value.
I recommend you read the curriculum for a refresher, it really is the best at explaining the concepts.
When considering option bonds it helps to look through the yield curve and imagine the forward rates, as these are ultimately what determine whether an option is executed at each node. That will help when considering changes in YC slope.
Please don’t ask what happens when curvature of YC changes, my brain might melt.
Hehe thanks. I should’ve stuck to CFAI for such topics, but then gave in to desperate times