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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. Compared with an otherwise identical option-free bond, the callable bond's effective duration is most likely:

The callable bond's effective duration is shorter. With the call option deep in the money, price appreciation is capped near the call price, so the bond is less sensitive to yield changes than an otherwise identical option-free bond.

  1. Ashorter, because the price is capped near the call priceCorrect
  2. Bthe same, because the cash flows are fixed
  3. Clonger, because the issuer may extend maturity

Explanation

When a call option is deep in the money, the bond's price is limited by the call price, so it responds little to yield changes, giving a low effective duration. Option B ignores that effective duration accounts for changing cash flows. Extension risk applies to when rates rise, not here.

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