I have read on the notes that when an upward sloping yield curve flattens, call options increase in value while put options decrease in value?
If I use the put-call parity equation
Co= - X/(1+rf)t + Po + So
If the rf decreases the call option should decrease, whis is commented in this link: http://www.analystforum.com/forums/cfa-forums/cfa-level-i-forum/91315220
As the curve flattens, longer term yields fall. Since there is a negative relationship between yields and call option values, the call options will increase in value.
Remember that the probability of calling a callable bond increases when bond prices increase (ie. when yields fall).
Agree with you. If interest rate decrease the vaule of the call will become valuable (and the price of the callabe bond will decrease) because the owner of the option would have the “option” to issue new bonds at a lower maket rate.
For putable bonds, is the other way around. If intereset rate decreases, the option may be “worthless” since an investor who has bought the option is better off by holding the bond (which has hihger coupon than the yield in the market).
By the way the put call parity from the first post, have nothing to do with vauing option for bonds. Its applicable for stocks but not for bonds.
Put call parity is valid for options, regardless of the underlying.
The problem with using put/call parity for options on bonds is that the value of the underlying is affected directly by interest rate changes, which isn’t (necessarily) the case for options on stocks.
That’s not to say that it doesn’t hold; things are simply a lot more complicated.
if you are looking at page 327 exhibit 8, I’ve just written to CFAI to moan about it. To me it’s wrong & doesn’t match the text.
^ Can someone explain exhibit 8? I don’t get why it’s upward sloping from 2% to 4% and downward sloping from 6% to 4%. Wouldn’t it make more sense if it was upward sloping, let’s say, from 3% to 5% and downward sloping from 3% to 1%?
I’m assuming the diagram just says as the yield goes up in the long run, bond prices fall and therefore the value of the embedded call option decreases and vice versa?
to explain exhibit 8,- just take a whole bunch of 4 letter words and arrange them as you please.
Hello, I have been struggling with his concept for a couple of days already. Hope you can explain a little more to me. Thank you!
Under the Option chapter, the notes mentions that “the higher the risk free rate, the higher the Call Option Price”. However, like the qution posted, “as an upward sloping yield curve becomes flatter, the Call Option Calue increses” which means the “lower the interest rate, the higher the call option value will be”. This is exactly the opposite what the option chapter says unless there is no direct relationship between the Call Option Price and Call Option Value.