What is the relationship between the price of a straight bond and the price of a callable bond?
A. The straight bond's price will be higher than the callable bond's price for low interest rates.
B. The straight bond's price will be lower than the callable bond's price for low interest rates.
C. The straight bond's price will change as interest rates change, but the callable bond's price will stay the same.
D. The straight bond and the callable bond will have the same price.
E. There is no consistent relationship between the two types of bonds.
A. The straight bond's price will be higher than the callable bond's price for low interest rates.
For low interest rates, the price difference is due to the value of the firm's option to call the bond at the call price. The firm is more likely to call the issue at low interest rates, so the option is valuable. At higher interest rates the firm is less likely to call and this option loses value. The prices converge for high interest rates. A graphical representation is shown in Figure 14.4.
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