Question

Explain why a callable bond's price would be expected to decline less than an otherwise comparable option-free bond when interest rates rise?

Answer 1

An option free bond is a bond that has the underlying asset as a bond but it does not have the option of calling the bond embedded in it. A callable bond however, has the option to call a bond before the maturity of the bond. When the interest rates rise, then the price of the bond will fall but the embedded call option will lead to the fall in the price of the callable bond to be less. This is because the price of call option increases as the interest rate rises. Hence, in a callable bond the price decreases but the effect of the decrease is offset by the presence of an embedded call option. Hence the fall will be a little less than option free bond where there is no embedded call option.