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CFA Level I · CFA Level I Exam · Fixed-Income Cash Flows and Types

A 10-year bond has a put option exercisable by the investor at par in year 5. Interest rates rise sharply after issue. The investor's most likely action and the primary reason are:

The investor will most likely exercise the put. Rising rates push the bond's market price below par, so selling back at par is worth more than holding, and the proceeds can be reinvested at the new higher yields.

  1. Ahold the bond, because the coupon is fixed
  2. Bexercise the put, because the bond trades below par and the proceeds can be reinvested at higher ratesCorrect
  3. Cexercise the put, because the bond trades above par and a gain can be locked in

Explanation

When rates rise, the market price of a fixed-coupon bond falls below par. A put at par lets the investor sell above market value and reinvest at the higher rates. Exercising when the price is above par would be irrational, since the put would be out of the money.

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