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

Describe the value maximisation criterion, Describe the value maximisation ...

Describe the value maximisation criterion In applying the value maximisation criterion, term value is used in terms of worth to the owners, which is, ordinary shareholders. Cap

Explanation and definition of the mos, a) i = 800 units, ii = 250 units, ii...

a) i = 800 units, ii = 250 units, iii = 60% b) Explanation and Definition of the MOS. Play-it has the better MOS in absolute terms, although Tread-it has the better MOS when mea

Chi square distribution, Chi Square Distribution If the difference betw...

Chi Square Distribution If the difference between actual and the expected frequencies is zero, the sampling distribution of the chi square statistic c 2  will be identical to a

Determine the factors of auditors, Determine the factors of auditors Wh...

Determine the factors of auditors When anticipating to apply analytical review as a substantive procedure, auditors determine a number of factors like: Factor

What is the financial leverage effect and what causes it, What is the finan...

What is the financial leverage effect and what causes it?  What are the potential benefits and negative consequences of high financial leverage? Monetary leverage is the additi

How to develop career strategy, Q. How to develop career strategy? in t...

Q. How to develop career strategy? in this step employees need to focus on developing the knowledge experience and skills necessary to market self to prospective organizations.

Letter of credit (loc), Letter of Credit (LOC) A popular bank instrumen...

Letter of Credit (LOC) A popular bank instrument begins that a bank has granted the holder an amount of credit equal to the face amount of the L/C. A bank guarantees payment of

How would the market price of a bond be affected, All other things held con...

All other things held constant, how would the market price of a bond be affected if coupon interest payments were made semiannually instead of annually? The majority of bonds i

Calculate profitability index, XYZ Ltd is a manufacturer and distributor of...

XYZ Ltd is a manufacturer and distributor of agricultural equipment. XYZ produces milking machines and supplies as well as being the sole Australian distributor of machinery from t

The mechanism of a swap in risk management, QUESTION i) Discuss the ris...

QUESTION i) Discuss the risk associated with changes in exchange rates. ii) How can these risks be managed internally? iii) Explain how a manager can use a forward contra

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