Contrast the effective convexities of straight, callable and putable bonds
The idea
Effective convexity is (PV₋ + PV₊ − 2 × PV₀) ÷ (ΔCurve² × PV₀). An option-free bond has positive convexity: its price rises more when rates fall than it falls when rates rise. A callable bond near its call price has negative convexity, because the call caps the upside, while far from the call it behaves like the straight bond. A putable bond keeps positive convexity and, near its put price, has more than the straight bond, because the put limits the downside. A common slip is to forget to square ΔCurve in the denominator, or to invert the sign by subtracting the other way, which turns the callable bond's negative convexity positive.
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Take the free diagnostic →More in Valuation and Analysis of Bonds with Embedded Options
- Explain bonds and other debt securities that contain embedded options
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- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
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- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
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- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework
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