Question #41

of 98 For a convertible bond without any other options, the call feature implied by the convertibility feature will do all of the following EXCEPT: A) increase the value of the bond over that of a comparable option-free bond. B) cause negative convexity. C) place a lower limit on the possible values of the bond. Explanation Negative convexity is caused by the bond being callable where the issuer has the embedded call option. Negative convexity does not apply to convertible bonds. The convertibility feature gives the bondholder a call option on the shares of common stock of the issuer. This increases the price of the bond and places a lower limit on the possible values of the bond. However, that lower limit will change with the price of the common stock. (Module 27.8, LOS 27.n) George Nagy is a fixed income manager with Luna Securities. Nagy is analyzing several securities issued by Redna, Inc. First, he is looking at a three-year, annual-pay floating rate note with an embedded cap of 6.5% paying coupons in arrears. Nagy's assistant has provided him with the binomial interest rate tree below (computed with assumed volatility of 25%) to aid in her analysis. T0 T1 T2 9.892% 7.704% 6% 6% 4.673% 3.639% A three-year, Redna, Inc., callable bond is currently trading at a price of $102. An otherwise identical straight bond is also trading. Nagy obtains the report of the firm's chief economist indicating that rates are trending lower.