Value of Option-free bond is not affected by Yield volatility???

CFA Level II Fixed Income
#1

As interest rates (yields) go up or down, the price of the bond will change… why is the statement above correct or incorrect???

#2

For simplicity’s sake: take a bond paying 7% annually issued at par - $1,000 (when market rates for similar issues are at 7%).

Now, one year later, the market rate for similar bonds is 6%. The original bond in the example is paying $70 every year but new bonds are only paying $60, so logic tells us that an investor would pay more (a premium) for the original bond because its paying a higher coupon.

Thus, the decrease in interest rates has caused the price of the bond to increase (inverse relationship).

The exact opposite is true for an increase in rates.

Did i just get suckered in by a troll?

#3

Is the statement correct or not???

#4

Well, yes…yes, it’s correct.

And a follow up question for you: how’d you perform on L1 Fixed Income?

#5

They’re not saying that the price isn’t affected by changes in yield; of course they are.

They’re saying that today’s price is a function of today’s yield, but not yesterday’s, last week’s, or last month’s. If the yield today is 4.312%, then to compute the price today you discount at 4.312%, whether the interest rate volatility is 0.5% or 1.0% or 3.5%.

The point they’re trying to make is that interest rate volatility affects the value of embedded options – just as volatility of the underlying affects the value of all other types of options (see Black-Scholes-Merton) – but it doesn’t affect the value of the option-free bond.

#6

I guess one can say that the value of an option-free bond is affected by the level of interest rate but not by the volatility of interest rates.

#7

Bingo!

#8

Yup! Vol is not used in pricing an option free bond.

#9

Thanks to all!

#10

You’re welcome.