Final answer:
When interest rate volatility decreases, the Option-Adjusted Spread (OAS) for callable bonds generally increases due to the reduced risk of bonds being called before maturity. The change in interest rates affects a bond's present value; an increase in rates decreases it, while a decrease in rates increases it.
Step-by-step explanation:
As interest rate volatility declines, the Option-Adjusted Spread (OAS) for callable bonds generally increases. This is because the OAS compensates investors for the risk that a bond may be called away from them before maturity, typically when interest rates fall and the issuer can refinance at a lower rate. With less volatility, there's a lower likelihood of rates falling significantly, thus reducing the risk of the bonds being called. Consequently, the justification for a higher yield diminishes, and the OAS expands to reflect the decreased risk.
When considering bond pricing and interest rates, if you have a bond when interest rates are at 8% and they rise to 11%, the bond's present value would decrease. This is due to the fact that the fixed future dollar payments are now discounted at a higher interest rate, leading to a lower valuation if you try to sell the bond. Conversely, if interest rates fall after a bond is issued, the bond will sell for more than its face value as it locks in a higher interest rate compared to the market.