Interest Rate Volatility and Callable Bonds Valuation

Very Hard Term Structure Dynamics Interest Rate Volatility

In a recent analysis for their fixed income portfolio, an institutional investor studied the behavior of interest rates using a term structure model that reflects the dynamics of interest rate volatility. This model incorporates the factors affecting yield curves, particularly emphasizing how changes in interest rate volatility can affect the pricing and risk assessment of various fixed income securities. The investor is particularly interested in how shifts in the volatility may impact the option-adjusted spread (OAS) of a callable bond compared to a similar non-callable bond.

Given this context, which of the following statements is most accurate regarding the relationship between interest rate volatility and the valuation of callable bonds?

Callable bonds tend to have a higher price when interest rate volatility increases because the likelihood of the bond being called increases.

Callable bonds tend to have a lower price when interest rate volatility decreases due to reduced prepayment risk.

Callable bonds exhibit less sensitivity to changes in interest rate volatility compared to non-callable bonds because their valuation depends primarily on the exercise option.

Hint

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