CFA Level I · CFA Level I Exam · Curve-Based and Empirical Fixed-Income Risk Measures
A portfolio manager holds a callable bond and a straight bond with the same maturity and coupon. If interest rates are expected to fall substantially, the manager's expected price appreciation is most likely:
The straight bond is expected to appreciate more. When rates fall, the callable bond's price is capped near its call price because the issuer can redeem it, a feature called price compression, while the straight bond's price continues to rise.
- Agreater for the callable bond because its coupon is reset lower
- Bsimilar for both bonds because they have identical maturities
- Cgreater for the straight bond because the callable bond's price rise is capped near the call priceCorrect
Explanation
With falling rates the issuer is likely to call, so the callable bond's price compresses toward the call price (price compression). The straight bond has no such cap and its price keeps rising with positive convexity.
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