Three bonds were issued by the same company about four years ago. The three bond
ID: 2785387 • Letter: T
Question
Three bonds were issued by the same company about four years ago. The three bonds have similar maturities and coupons. Bond A is callable, Bond B is putable, and Bond C is option-free.
Statement 1: If interest rates decline, Bonds B and C will have higher market prices than Bond A.
Statement 2: If interest rates increase, Bonds A and C will have higher market prices than Bond B.
Both statements are correct.
Both statements are not correct.
Only statement 1 is correct.
Only statement 2 is correct.
A.Both statements are correct.
B.Both statements are not correct.
C.Only statement 1 is correct.
D.Only statement 2 is correct.
Explanation / Answer
If interest rates decline, the callable bonds are most likely to be called. A decline in interest rates will result in an increase in bond prices. Hence, all bonds price will go up but the price of bond A, which is callable bond will be capped upto the call premium. Hence, the first statement is correct.
When interest rates increases, the putable bonds are most likely to be sold back to the issue. Also, when rates increase, bond price goes down. Due to the put option, the value of bond B will not go down as much as the other bonds. Hence, Bond B will have a higher market price than Bond A and C. Hence, second statement is incorrect.
Hence, option C is correct.
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