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CFA Level I · CFA Level I Exam · Curve-Based and Empirical Fixed-Income Risk Measures

An analyst compares a callable bond with an otherwise identical option-free bond. When market yields fall sharply, the effective convexity of the callable bond is most likely:

The callable bond's effective convexity is lower than the option-free bond's and can turn negative. When yields fall, the call option limits price appreciation, flattening and then bending the price-yield curve downward, while the option-free bond keeps its positive convexity.

  1. Ahigher than that of the option-free bond
  2. Bequal to that of the option-free bond
  3. Clower than that of the option-free bond, and possibly negativeCorrect

Explanation

As yields fall, the issuer's call option moves toward the money and caps the callable bond's price rise, so its price-yield curve bends downward (negative convexity). The option-free bond keeps positive convexity. So the callable bond's effective convexity is lower and can be negative.

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