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

Beta, what is the value of beta for this fund ? If the benchmark index for ...

what is the value of beta for this fund ? If the benchmark index for this mutual fund increased by 11.00% during the period covered by beta measure, what was the rate of return for

Define the term- cash purchases, Define the term- Cash purchases     Shar...

Define the term- Cash purchases     Shareholders of the target company are bought out completely and have no further stake in business. This is good if predator shareholders want

Defien the term ension funds, Pension funds Pension funds offers retire...

Pension funds Pension funds offers retirement income in the form of annuities to employees covered by a pension plan. They obtain contributions from employers or employees and

Explain the diversify investor's portfolio internationally, Why might it be...

Why might it be very simple for an investor desiring to diversify his portfolio internationally to buy depository receipts as compared to the actual shares of the company? Answ

Define minimum price make producers as a whole worse off, Suppose the gover...

Suppose the government regulates the price of a good to be no lower than some minimum level. Can such a minimum price make producers as a whole worse off?  Explain. As a higher

Financial and strategic analysis, Evaluate the firm’s financial standing fo...

Evaluate the firm’s financial standing for the past 5 years: • Undertake a financial and strategic analysis of its performance: o Use the Assignment Questions for guidance ON

Financial management and production department, The production department i...

The production department in any firm is concerned with provision of production facilities, production cycle, skilled and unskilled labor, storage of finished goods, capacity utili

George thomas, which type of financing is appropriate to each firm

which type of financing is appropriate to each firm

Describe concepts of finance function, Q. Describe Concepts of finance func...

Q. Describe Concepts of finance function ? 1) The finance function in the business task in the providing funds needed by the enterprises on the term that one most favorable in

Allocation head for revenue expenditure, Q. Allocation head for Revenue Exp...

Q. Allocation head for Revenue Expenditure? All revenue expenditure is recorded in revenue allocation registers by various heads of accounts classification, The expenditure on

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