D)QUESTION #70 OF 88 QUESTION ID

47.d)

Question #70 of 88

Question ID: 463791

Johnson asks Wall to compute the value of the call option. Using the given information what is the value of the embedded call option?

ᅚ A)

$2.04.

ᅞ B)

$1.21.

ᅞ C)

$0.00.

Explanation

The call option value is simply the difference between the value of the callable and the non-callable bond.

Call Option Value = $100.83 − $98.79 = $2.04 (Study Session 14, LOS 47.e)

Question #71 of 88

Question ID: 463792

Wall is a little confused over the relationship between the embedded option and the callable bond. How does the value of the embedded

call option change when interest rate volatility increases? The value:

ᅞ A)

decreases.

may increase or decrease.

ᅚ C)

increases.

All option values increase when the volatility of the underlying asset increases. This is due 47.e)

Question #72 of 88

Question ID: 463793

Wall wonders how the value of the callable bond changes when interest rate volatility increases. How will an increase in volatility affect

the value of the callable bond? The value:

The value of the callable bond decreases if the interest rate volatility inreases because the value of the embedded call option increases.

Since the value of the callable bond is the difference between the value of the non-callable bond and the value of the embedded call

option, its value has to decrease. (Study Session 14, LOS 47.e, f)

Question #73 of 88

Question ID: 463794

Wall now turns his attention to the value of the embedded call option. How does the value of the embedded call option react to an

increase in interest rates? The value of the embedded call is most likely to:

decrease.

increase.

remain the same.

There are two different effects that an increase in interest rate will cause in this situation. The first (and primary) impact stems from the

relationship between interest rates and bond values: when interest rates increase, bond values decrease. Since the underlying asset to

the option (the bond) decreases in value, the option will decrease in value also. The second (and much smaller) effect stems from the fact

that when interest rates are higher, call option prices are generally higher because holding a call (rather than the underlying) is more

attractive when interest rates are high. However, this secondary effect is likely to be smaller than the impact of the change in bond value.

(Study Session 14, LOS 47.e, f)

Question #74 of 88

Question ID: 463795

Wall believes he understands the relationship between interest rates and straight bonds but is unclear how callable bonds change as

interest rates increase. How do prices of callable bonds react to an increase in interest rates? The price:

Since the bond has a fixed coupon it becomes relatively less attractive to investors when interest rates increase. Its cash flows are now

discounted at a higher discount rate which reduces the value of the bond. (Study Session 14, LOS 47.e, f)

Question #75 of 88

Question ID: 463856

The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

bond has more upside potential.

ᅚ B)

bond has lower downside risk.

conversion premium.

The straight value of the bond forms a floor for the convertible bond's price. This lowers the downside risk. The conversion premium is a

disadvantage of owning the convertible bond, and it is the reason the bond has lower upside potential when compared to the stock.

Question #76 of 88

Question ID: 463813

Using the following tree of semiannual interest rates what is the value of a 5% callable bond that has one year remaining to maturity, a

call price of 99 and pays coupons semiannually?