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

Compared with an otherwise identical option-free bond, a callable bond's price-yield curve is most likely to exhibit which behavior when market yields fall well below the coupon rate?

The callable bond shows negative convexity when yields fall well below the coupon. The likelihood of the issuer calling the bond rises, so the price is held near the call price and cannot keep climbing like an option-free bond's price.

  1. ANegative convexity, with price appreciation capped near the call priceCorrect
  2. BPositive convexity, with price rising faster than the option-free bond
  3. CZero convexity, with price moving linearly as yields decline

Explanation

When yields fall, the issuer is more likely to call the bond, so the call price acts as a ceiling on the price. The curve flattens and bends downward, which is negative convexity. The option-free bond keeps rising at an increasing rate, so the second option is wrong.

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