#45

Question 1

valuing embedded options

Answer 1

LOS 45.b

enbedded calls:

Vcall = Vstraight - Vcallable

“investors get a discount”

embedded puts:

Vput = Vputable - Vstraight

“investors pay a premium”

Question 2

volatility’s effect on bonds and embedded options

Answer 2

LOS 45.d

Straight bonds: value not affected by volatility

when volatility rises:​

• Value of enbedded options go up
• Vcallable– = Vstraight - Vcall++
• Vputable++ = Vput++ - Vstraight

Question 3

level and shape of YC

Answer 3

LOS 45.e

• upside of Callable bond limited when rates decline
• downside of Putable bond limited when rates increase
• upward-sloping YC: call option = low value but put option = high value
• YC flattens: call option = high value but put option = low value