Bond with call and prepay options, Financial Management

Assignment Help:

Let us consider a bond with callable or prepayable feature. Figure shows the price/yield relationship of option-free bond and callable bond. The price yield relationship of option-free bond is represented by the convex curve a - a'. The price yield relationship of the callable bond is represented by the unusual curve a -b.

When market yield for comparable bonds is higher than the coupon rate on the callable bond then issuer will not call the bond. For example, if the coupon rate on a bond is 8% and the prevailing market yield on comparable bond is 13%, then undoubtedly issuer will not call the bond. Because the issuer of the bond is unlikely to call it, the price/yield relationship of callable bond is equal to the option-free bond. Therefore, the callable bond is valued as an option free bond. However call option still has some value, so the bond is not exactly priced like an option free bond.

If yield decreases in the market then there is a chance that issuer will call the bond. It is not necessary that issuer exercise the call option as market yield drops below the coupon rate. However, as yield approaches the coupon rate from higher yield level, the value of the embedded option increases. For example, assume that yield decreases from 13% to 8.75%; then it is most likely that issuer will not exercise the call option. But the issuer would probably exercise his right to call if the market yield declines further. The call option becomes more valuable to the issuer in this circumstance, thus reducing the price of the callable bond when compared to that of a comparable option-free bond. In figure 5, the value of the embedded call option at a given yield can be measured by the difference between the price of an option-free bond and the price on the curve a - b. We can also notice that at low yield levels, the value of the embedded call option is high.

Let us see how the price volatility property of a callable bond is different from that of an option-free bond. Figure 6 magnifies the portion of the price/yield relationship for the callable bond where the two curves in the figure depart. (Segment b - b' in figure ). As per property 4, when there is a large change in yield of a given number of basis points, the price of an option-free bond increases more than it decreases. But in case of a callable bond, the opposite is true i.e. for a given large change in the yield, the price of the bond appreciation is less than the price decline.

Let us look into the price volatility characteristic of a callable bond. From figure 1 it is clear that the curve has a concave shape. In financial terms, this is referred to as negative convexity. This characteristic of callable bond is not exhibited at every yield level.

When yield is high (in comparison to coupon rate), the bond shows same price/yield relationship as an option-free bond; and therefore at this level the gain is greater than the loss. The price/yield relationship of a option-free bond is referred to as positive convexity. Therefore, for a callable bond, we see negative convexity character at low yield levels and positive convexity character at high yield levels. This is illustrated in figure 2.

Figure 1: Negative Convexity Region of the Price/Yield Relationship for a Callable bond

1555_negative convexity.png

Figure 2: Negative and Positive Convexity Exhibited by Callable bond

1114_negative convexity1.png

We see in Figure 7 that at certain yield levels, when rates decline there is very little price appreciation. A bond is said to exhibit "price compression," when it enters this region.


Related Discussions:- Bond with call and prepay options

Dividend policies, explain for factors influencing design for dividend poli...

explain for factors influencing design for dividend policies

Why do a split, Why do a Split? A 4 x 1 Split is an operation by which ...

Why do a Split? A 4 x 1 Split is an operation by which a shareholder now owns 4 shares for every share he/she had before. Logically, the stock market value of each of these new

Determine the earnings per share, Goodshape Company has currently, an ordin...

Goodshape Company has currently, an ordinary share capital of Rs. 2.5 million, consisting of 25,000 shares of Rs. 100 each. The management is planning to raise another Rs. 2 milli

Define the term shareholders, Shareholders Shareholders are usually ass...

Shareholders Shareholders are usually assumed to be interested in wealth maximisation. This though involves consideration of potential return and risk. Where a company is liste

Rejecting proposed projects when using internal rate of retu, What is the d...

What is the decision rule for accepting or rejecting proposed projects when using internal rate of return? Whenever the internal rate of return is equal or greater than to the

Explain the reconstruction and effect on share price, Reconstruction and ef...

Reconstruction and effect on share price A listed company facing reconstruction (divestment, demerger, MBO etc) will have informed the stock market in advance and the share pri

What is the matching principle of working capital financing, What is the ma...

What is the matching principle of working capital financing?  What are the benefits of following this principle? The matching principle is while short-term financing is used fo

Determine the financial requirements of the business, Q. Determine the fina...

Q. Determine the financial requirements of the business ? Decisive the Financial Needs: - The initial task of the financial management is to estimate and determine the financia

Explain life insurance in detail, Question 1 Insurance is protection again...

Question 1 Insurance is protection against possible financial loss. Explain life insurance in detail Question 2 Mutual funds are a composite of stocks, bonds, and securities,

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd