Question #91

of 98 For a callable bond, the value of an embedded option is the price of the option-free bond: A) minus the price of a callable bond of the same maturity, coupon and rating. B) plus the price of a callable bond of the same maturity, coupon and rating. C) plus the risk-free rate. Explanation The value of the option embedded in a bond is the difference between that bond and an option-free bond of the same maturity, coupon and rating. The callable bond will have a price that is less than the price of a non-callable bond. Thus, the value of the embedded option is the option-free bond's price minus the callable bond's price. (Module 27.1, LOS 27.b) Patrick Wall is a new associate at a large international financial institution. Wall has recently completed graduate school with a Master's degree in finance, and is also currently a CFA Level I candidate. His previous work experience includes three years as a credit analyst at a small retail bank. Wall's new position is as the assistant to the firm's fixed income portfolio manager. His boss, Charles Johnson, is responsible for getting Wall familiar with the basics of fixed income investing. Johnson asks Wall to evaluate the bonds shown in Table 1. The bonds are otherwise identical except for the call feature present in one of the bonds. The callable bond is callable at par and exercisable on the coupon dates only. Table 1: Bond Descriptions Non-Callable Callable Bond Price $100.83 $98.79 Time to Maturity (years) 5 5 Time to First Call Date -- 0 Annual Coupon $6.25 $6.25 Interest Payment Semi-annual Semi-annual Yield to Maturity 6.0547% 6.5366% Price Value per Basis Point 428.0360 --