Guys I was doing a problem in Kaplan a while ago and it basically said that when interest rate vilatility rises, option cost rises and the value of a callable bond decreases. But this decrease causes it to be overvalued. Why does a decrease in value imply that it is overvalued?
P
it would help to see the question.
The only interpretation I can think of is if you adjust your own estimates of volatility into your model. Your model will say the bond is worth less than what it is in market, so it seems overvalued.
Again, without seeing the actual question it’s difficult to say. Saying that “increasing interest rate vol causes callable bonds to be overvalued” is simply not true, so there must be more to question.