Question #94 - Reading 27 Valuation and Analysis of Bonds With Embedded Options

Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options

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Shared Context

- Wall is a little confused over the relationship between the embedded option and the callable bond. How does the value of the embedded call option change when interest rate volatility increases? The value: A) may increase or decrease. B) increases. C) decreases.

Question

Wall now turns his attention to the value of the embedded call option. How does the value of the embedded call option react to an increase in interest rates? The value of the embedded call is most likely to:

Answer Choices:

A. increase

B. remain the same

C. decrease. Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corporation, Hardin's competitor, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%)

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