hope i don’t sound dumb but i couldn’t think through this… with the call-put parity equation, interest rate increases, call option increase in value as to put option decrease in value. C=S+P- X/(1+RFR)^T P=C-S+ X/(1+RFR)^T Okay… so i got that… But then as comparing a callable bond to option free bond, the call option value increases as the yield decreases, and when the yield increases, the callable bond value became like the option free bond. Doesn’t this mean that call-option value diminish as to callable bond=option free-call option can someone please explain this to me… and damn… it’s 2am already…
im not sure what your question is, but you are right that as the yield increases, the callable bond behaves just like (and is priced just like) the noncallable bond. i dont see the relation you are trying to make between callable bonds an call options. The “C” in put call parity refers to a call option–not a bond.
i am getting mixed up with put call parity and callable bonds option… humm… i m trying to say… when interest rate rise, the callable bond’s call option value decreases, where as in put call parity, the call option value increases… and show NY i remember you said you taking the exam in sheraton?? is that in the city??
understood your q … but can’t get the answer … anyone?
Actually, when interest rates increases, the price of a callable bond will not fall as much in comparison to a non-callable bond… it’s in the book 5 CFAi page 286 bullet point 7, does this mean the same as when yield increases (= interest rate increase)?
I think that you are going to be messed up trying to use put call parity with callable bonds. Put call parity for a bond call is weird, because it says that Risk-free bond + call = risky bond + put i.e., the bonds on each side is different. Now when you have a bond with an embedded call, it’s hard to figure out how that could be useful (ok, I can think of some ways, but not especially useful here). Anyway, just think about it the easy way. When you own a callable bond, someone else can call it. They would want to call it when interest rates went way down. That means that decreases in interest rates don’t help you as much as they would if the bond is not callable. It works exactly the same when interest rates increase. (rf - Yield and interest rates are synonyms here).
jeffwey Wrote: > But then as comparing a callable bond to option > free bond, the call option value increases as the > yield decreases, and when the yield increases, the > callable bond value became like the option free > bond. > Doesn’t this mean that call-option value diminish > as to callable bond=option free-call option > > can someone please explain this to me… > and damn… it’s 2am already… The call option on the bond is held by the issuer. Think of it as the option to refinance the bonds. The issuer is more likely to refinance as yields drop. Hence, as yields drop, the option to refinance becomes more valuable. So, the option value increases. Likewise, the option to refinance becomes less valuable as yields rise (i.e. the issuer is less likely to refi). Since the value of a callable bond equals the value of a non-callable bond less the value of the call, as yields rise high enough, the callable bond therefore becomes closer and closer ion value to a non-callable bond.
Put-Call parity as taught in L1 is about puts and calls on stock prices. Don’t use it for embedded puts and calls in bonds. There is presumably a version of P-C parity that works for bonds, and Joey really knows his stuff on this, so I’d feel very comfortable accepting his version just because he said it… BUT… don’t worry about it for the exam. Calls on bonds are strange because they buyer of the bond is simultaneously selling a call option… in most other situations, the “buyer” is receiving the call option. So the buyer of a callable bond has sold a call option; the buyer of a putable bond has bought a put option. Probably best just to remember that callable bonds need an extra 10 seconds to think it through. To make it weirder… those are calls based on interest rates, not stock or bond prices (though there is presumably a way to translate it to an equivalent price). At Level 1, the important thing to remember about callable bonds is that they create negative convexity, which basically means that the price converges to the call price as interest rates go to zero (normally the price will just keep rising as rates go to zero)
okay… thanks guys… it’s just the questions that came up in mock 2, even though i got them right because when i did the question i didn’t think of them together since they came up in different sections, but later on i got confused… But i guess the questions … hopefully , on the exam will be clear what’s what…
When interest rates increase, call option value decreases and vice versa. When interest rates increase, there is no benefit from calling the bond. If the bond is called, it has to be reissued at a higher rate (current rate is higher). On the other hand, when interest rates decrease, call option value increases. The reason is that they can call the bond and reissue at a lower rate.
Put-call parity w embedded options:
Value(C) – Value(P) = PV(Forward price of bond on exercise date – Exercise price)
- Exercise Price = Callable/Putable value
- Forward price of bond on exercise date = Value of bond in backward induction process