Explain how an increase in expected interest-rate volatility can decrease the value of
a callable bond.
What will be an ideal response?
From an investor's point of view, they have sold a call option to the firm. The firm will exercise its call option when interest rates fall by enough to make it worth the company's costs to refinance its debt at a lower interest rate. The probability of this fall occurring increases when there is greater volatility in interest rates.
If and when interest rates fall, investors will have to "sell" their bonds back to the firm. If they want to invest the money received in bonds, they will have to purchase bonds with lower coupon payments. Thus, as expected interest-rate volatility increases, then the value of holding a callable fond can decrease.
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