Question #44 - Reading 27 Valuation and Analysis of Bonds With Embedded Options

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

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Shared Context

- Which of the following statements is/are correct? Statement I: The straight bond should trade for less than $102. Statement II: If interest rate volatility were to increase then the price differential between the two Redna bonds would widen. A) Both statements are correct. B) Statement I is correct but Statement II is incorrect. C) Statement I is incorrect but Statement II is correct. Explanation The straight bond will be priced higher, as the investor will not have the risk of the bond being called. If interest rate volatility rises then the call option will become more valuable, and the price differential will widen. (Module 27.1, LOS 27.b)

Question

Using the report of the economist, which of the following order of effective durations (highest to lowest) of otherwise identical bonds is most accurate:

Answer Choices:

A. callable, putable, straight

B. straight, callable, putable

C. straight, putable, callable. Explanation Since the rates are trending lower, the call option is likely to be exercised while the put will not. Therefore the effective duration of callable < effective duration of putable. Otherwise identical straight bonds will always have a higher (or same) effective durations than either callables or putables. (Module 27.5, LOS 27.j)

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