Question #98 - 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 most accurate regarding Diffle's calculation of duration and convexity? A) The duration estimate will be inaccurate since it does not account for any change in cash flows due to the call option embedded in the Hardin bond. B) The estimates for both duration and convexity will be inaccurate because the OAS was not estimated again after the rate shock. C) The duration estimate for the Bratton bonds will reflect the projected percentage change in price for a 100-basis-point change in interest rates. Explanation The duration formula given will calculate the percentage change in price for a 100 basis point change in yield, regardless of the actual change in rates used to derive BV– and BV+. The standard backward induction process would ensure that the derived values of BV– and BV+ reflect any potential change in cash flows due to embedded options. (Module 27.6, LOS 27.l)

Question

Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Indicate whether the statements made by Diffle in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct.

Answer Choices:

A. Both statements are correct

B. Only the statement regarding the effect of the volatility assumption is correct

C. Only the statement regarding the value of the embedded option is correct. Explanation Statement 1 is correct. The value of the option would be the difference between the value calculated with no call feature (the Bratton bonds) and the value calculated assuming the bond is callable (the Hardin bonds). Recall that the vignette stated the Bratton and Hardin bonds were identical except for the call feature in the Hardin bonds. The option value would therefore be: 100.915 – 100.472 = 0.443. Statement 2 is also correct. Increased volatility would increase the value of the option, thus lowering the value of the callable bond. (Module 27.5, LOS 27.j)

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