Bonds with Embedded Options (Reading 44)- Please Help

CFA Level II Fixed Income
#1

I’ve really struggled with the logic behind these two statements. Can someone tell me if the way I’m interpreting them is correct? - “If call price is increased, then the value of a callable bond will increase” My logic: If the call price is increased, then that means there’s a higher effective ceiling on the price of the bond, so it takes an even more dramatic drop in interest rates before the call option will be exercised. This reduces the value of the embedded call option which increases the value of the callable bond, since value of callable bond= value of straight bond-value of embedded call option - “If put price is increased, then the value of a putable bond will increase” My logic: If the put price is increased, then there’s a higher effective floor on the bond’s price so there’s a higher likelihood of the put option being exercised, which makes the put option more valuable. Hence, the value of the putable bond is increased since value of putable bond = value of straight bond + value of embedded put option

Can someone explain to me how this statement is correct? It came from the Wiley Study Guide notes.

Under LOS 44E Subheading Putable Bonds: The study guide states that the investor is effectively long on the embedded call option, so the value of the putable bond decreases less than that of the straight bond. I understand the reasoning of this equation: Value of putable bond = value of straight bond + value of embedded put. I also understand that as interest rates increase the value of the straight bond decreases but the decrease is partially offset by the increase in the value of the embedded put which provides the downside protection, therefore the decrease in value of the putable bond is less than that of the straight bond. I don’t understand why the investor is effectively long on an embedded call though- aren’t they long on the embedded put?

Thanks in advance!

#2

It sounds as though you understand each statement: your logic is sound and you reached the same conclusions as in the Wiley guide.

I don’t see a problem. Do you?

#3

this sounds like a typo. there is no embedded call option. they mean put i think?

#4

Thank you! After writing it all out I thought I had things straighted out, but I wanted to get a second opinion to confirm. I’m trying to rely as much as possible on logic and reasoning and not memorizing things unless it’s absolutely necessary.

#5

I think it’s a typo as well- but I thought I would get someone else’s thoughts on it before I made that assumption and moved on with my reviewing. thanks!

#6

Quote from Wiley: “If the put price is increased, the value of the callable bond will increase”

If put option is not embedded in the bond, how does put price affect callable bond at all?

#7

Seems like typo to me. Was interested in folks’ thoughts.