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CFA Level I · CFA Level I Exam · Yield-Based Bond Convexity and Portfolio Properties

A callable bond trades at a yield well below its coupon rate, so the call option is deep in the money. Its convexity is most likely:

The callable bond most likely has negative convexity. With yields low, the call becomes likely and the price approaches the call price, so gains from further yield declines are compressed. This is the opposite of the positive convexity of an otherwise identical option-free bond.

  1. Anegative, so price gains are compressed as yields fallCorrect
  2. Bpositive, and larger than that of an otherwise identical option-free bond
  3. Czero, because the call price caps the bond's price at all yield levels

Explanation

When yields fall far enough, the issuer is likely to call the bond, so its price rises less and less and approaches the call price. This price compression produces negative convexity. An option-free bond would have greater convexity, and the call price does not cap prices when yields are high.

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