CFA Level II ExamFixed IncomeMedium
A fixed-income analyst is comparing two bonds with embedded options: Bond X is a callable bond and Bond Y is a putable bond. Both bonds have identical coupon rates, maturities, and credit quality. If interest rates are expected to decrease significantly, which bond is likely to experience the smallest price appreciation, and why?
- ABond X, because its effective duration will increase as rates fall.
- BBond X, because its upside price potential is capped due to the call option.
- CBond Y, because its downside price protection limits its appreciation.
- DBond Y, because its effective duration will decrease as rates fall.
Show answer & explanationAnswer & explanation
Correct answer: B. Bond X, because its upside price potential is capped due to the call option.
When interest rates decrease significantly, the issuer of the callable bond (Bond X) is more likely to exercise the call option to refinance at lower rates. This caps the bond's price appreciation, making it less attractive to the investor. The putable bond (Bond Y), conversely, benefits from falling rates as the put option becomes less likely to be exercised, and the bond behaves more like an option-free bond, experiencing greater appreciation.
Why the other options are wrong
- A. As rates fall and the call becomes more likely, the effective duration of a callable bond tends to decrease, not increase.
- C. The put option provides downside protection, but it does not inherently limit upside appreciation when rates fall.
- D. As rates fall, the put option becomes less valuable and less likely to be exercised, and the bond behaves more like an option-free bond, so its effective duration would not necessarily decrease in a way that limits appreciation significantly.
Embedded Options and Price Behavior
Embedded options (call, put) significantly alter a bond's price sensitivity to interest rate changes compared to option-free bonds.
- Callable bonds have capped upside appreciation when rates fall.
- Putable bonds have floored downside depreciation when rates rise.
- Call options are beneficial to the issuer; put options are beneficial to the investor.
Memory trick: Options Offer Or Obstruct Outcomes.