I understand why a callable bond will be lower if the volatility is higher (because the embedded call will be higher), but why will this make it “closer to its actual market price”?? (schwerser, page 199, book 4 LOS - Explain how int rates volatility affects option adjusted spread)
Thanks to anyone who could shed some light.
A callable bond sells at a preimum to one without a call option due to the reinvestment risk taken on by the investor.
I need to be compensated for the fact that you can call away by bond whenever it benefits you. So maybe my callable bond trades at $105 when yours that doesn’t trades @ $100. As int rate volatility climbs, our option price does too, and thus lowers the price of our bond, bringing it closer to the value of our bond without the embedded call option.
That’s how I’d understand it at least
I have no idea what that sentence is supposed to mean.
There’s nothing I’ve found in the curriculum that approximates it.
I’d suggest that you e-mail Schweser and ask them what that sentence means.
Just think of it this way my friend:
We know that Z spread = OAS + option cost
If its a callable bond, option cost > 0; if its a puttable bond, option cost < 0
Then if interest rate volatility increase, option cost increase => (Assuming callable bond) OAS has to decrease to keep the equation in balance.
So this basically explains how changes in interest rate volatility affect OAS.
Thanks phutruongsy, i think that’s what i’ll do and keep going. I hate when schweser does that. I mean I understand they are trying to be consice but if they skip whole clarifying sentences, it’s NOT good!!
I think you might have something mixed up (investor requires higher yield, not higher price). For two bonds, identicial in all respects except one has an embedded call option, the one with the embedded call should trade at a lower price (cheaper for the investor to purchase). The cheaper price is how the investor is compensated for the additional risk of the bond being called away.
Example:
A straight bond, for example, is trading at par. For an identical bond (except) with an embedded call, the call diminishes the bond value (subtracted from the straight bond value). The callable bond would trade at less than par.
Correct me if I’m wrong (anyone). It’s late, and I’ve had a busy day, but I think this should be correct.
It was quoted in an OAS LOS if I recall correctly, it also made me stop and think for a few minutes.
It means a higher volatility will increase option cost and reduce the OAS for the same price (Z-spread). Thereby driving it closer to it’s “real” market price without an option.
Again, I don’t know what that means.
If the option cost increases, how does that drive it to the real market price _ without an option _?
It seems to me that the real market price without an option would have a low (i.e., zero) option value, not a high option value.
It’s badly written I agree.
In a binomial tree and an upward sloping yield curve, the higher the benchmark volatility used to derive interest rates, the lower the OAS you need to add for benchmark rates to correctly price a callable corporate bond. Which thus drives it close to it’s ‘real’ (benchmark) bond price (risk-free non-callable price).