Valuation of Bonds with Embedded Options

Correct Answer: The embedded call option reduces the value of the bond compared to a similar bond without the call feature.

The correct answer is that the embedded call option reduces the value of the bond compared to a similar bond without the call feature. An embedded call option gives the issuer the right to redeem the bond before maturity at a predetermined price. This is unfavorable for the bondholder because the issuer is likely to exercise the call option when interest rates have fallen, allowing them to refinance the debt at a lower rate. This leaves the investor with reinvestment risk, as they must reinvest the proceeds at a lower yield. The other two answers are incorrect: - The call option does not increase the bond's value, as it benefits the issuer, not the bondholder. - While some bonds may have both call and put options, the question does not mention a put option. Even if a put option were present, the call option would still negatively impact the bond's value from the investor's perspective.

Correct Answer: The value of the bond with the embedded call option will increase, but by a smaller amount compared to an option-free bond.

The correct answer is that the value of the bond with the embedded call option will increase, but by a smaller amount compared to an option-free bond. When interest rates decline, the value of bonds generally increases. However, a bond with an embedded call option will not increase in value as much as an equivalent option-free bond. This is because the call option gives the issuer the right to redeem the bond at a predetermined price before maturity. As interest rates fall, the likelihood of the issuer exercising the call option increases, limiting the potential price appreciation of the callable bond. The other two options are incorrect: - The value of the bond will not decrease due to the higher likelihood of the call being exercised. While the call option limits the upside potential, the bond's value still increases when rates fall, just not as much as an option-free bond. - The value of the callable bond will not increase by the same magnitude as an equivalent option-free bond. The embedded call option acts as a constraint on the price appreciation potential of the bond when interest rates decline.

Correct Answer: The value of the embedded put option increases, providing protection against the increased credit risk.

The correct answer is that the value of the embedded put option increases, providing protection against the increased credit risk. An embedded put option gives the bondholder the right to sell the bond back to the issuer at a predetermined price. When the credit risk of the issuer increases, the value of this put option also increases. This is because the put option becomes more valuable as a form of protection for the bondholder against the heightened risk of the issuer defaulting on the bond. The other two statements are incorrect: - The value of the put option does not remain unchanged when the issuer's credit risk increases. There is a direct relationship between the credit risk and the value of the embedded put. - The value of the put option does not decrease due to a reduced likelihood of the issuer honoring it. In fact, the opposite is true. As the credit risk increases, the put option becomes more valuable as it provides the bondholder with a way to mitigate potential losses by selling the bond back to the issuer.