Question: Given a parallel shift upwards in the yield curve, what is the most likely ordering in terms of expected decline in valuefrom least to mostfor

Given a parallel shift upwards in the yield curve, what is the most likely ordering in terms of expected decline in value—from least to most—for otherwise comparable bonds? Assume that the embedded options are deep out-of-the-money.

a. Callable bond, option-free bond, putable bond

b. Putable bond, callable bond, option-free bond

c. Putable bond, option-free bond, callable bond

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B is correct The value of a bond with an embedded option may be considered as the value of an optionfree bond plus the value of the embedded option While the upward shift in the yield curve will cause the optionfree component of each bond to depreciate in value this change in yieldstomaturity will also affect the value of embedded options For a putable bond the bond investor has the option to put the bond back to the issuer if yieldstomaturity rise The more rates rise the more valuable this embedded option becomes This increasing option value will partially offset the decline in value of the putable bond relative to the optionfree bond This can be seen in the lower panel of Exhibit 22 The dotted line for the putable bond has a flatter slope than the solid line for the optionfree bond its price will decrease more slowly as yieldstomaturity increase For a callable bond the bond issuer has an option ... View full answer

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