Chartered Financial Analyst (CFA) Practice Exam Level 2

What occurs in a callable bond's price behavior during rising interest rates?

1. The bond price consistently increases

2. The bond demonstrates negative convexity

3. The bond becomes less attractive to investors

4. The bond price remains stable regardless of rate changes

The correct answer is: The bond demonstrates negative convexity

In the context of callable bonds and their price behavior during periods of rising interest rates, it is important to understand the concept of negative convexity. Callable bonds are those that can be redeemed by the issuer before the maturity date, typically when interest rates fall. When interest rates rise, the likelihood of a callable bond being redeemed early diminishes, as it would be less advantageous for the issuer to call the bonds and refinance at higher rates. This causes the price of callable bonds to react differently than non-callable bonds. As interest rates rise, the price of a callable bond is constrained by the call option embedded in it, leading to a situation where the bond's price does not rise as quickly as a non-callable bond's price and can even decline. This phenomenon creates what is known as negative convexity. While non-callable bonds exhibit positive convexity (where price increases more dramatically as interest rates decrease), callable bonds have a flatter price response to interest rate movements when rates rise, which results in negative convexity. Therefore, the correct answer highlights that the bond demonstrates this unique characteristic in its pricing behavior during periods of rising interest rates. In contrast, other options suggest behaviors inconsistent with the nature of callable bonds. For example, the