Question

Consider a puttable bond and a callable bond issued by the same issuer with the same term to maturity. When the volatility increases from 10% to 15%, the difference between the price of non-callable (regular) bond and callable bond increases by $1. What does happen to the gap between the price of puttable and callable bonds?

a. It will increase exactly $1.
b. It will increase less than $1.
c. Depending on bond price, it can increase more or less than $1.
d. It will increase more than $1.

Answer 1

The gap between puttable and callable bonds prices will likely change when volatility increases, but the exact change in the gap depends on specific bond characteristics and market conditions, not necessarily by a fixed amount.

Step-by-step explanation:

When volatility increases, the value of both put and call options embedded in bonds will be affected, with greater impact on callable bonds because increased volatility makes it more likely that the issuer will call the bond if interest rates drop. Similarly, higher volatility makes the put option more valuable as it provides the bondholder with more protection. Therefore, when volatility increases from 10% to 15%, we can expect that the gap between the price of puttable and callable bonds will increase, but the exact amount will depend on the specific characteristics of the bond and the market conditions. Since the put option becomes more valuable, and assuming that there are no other changes in market conditions, the price of the puttable bond goes up, making option c. "Depending on bond price, it can increase more or less than $1" the most likely scenario.