Mark Davidson and James Case are bond traders at a large fixed-income investment firm. Both Davidson and Case have developed bond valuation models for bonds with embedded options. Using their respective valuation models, the traders have calculated the price of BMC Corp.'s callable and putable bonds. Davidson uses a yield volatility assumption of 23%, while Case uses an assumption of 31%. Other than the volatility assumption, the traders use identical inputs for the valuation models. Which of the following best summarizes the output of the two valuation models?
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A. B. C.A
The difference between Mark Davidson's and James Case's bond valuation models lies in their yield volatility assumptions. Davidson assumes a yield volatility of 23%, while Case assumes a yield volatility of 31%.
In bond valuation models, yield volatility is an important factor that affects the value of options embedded within bonds. When yield volatility is higher, the uncertainty surrounding the future yield movements increases, leading to greater potential fluctuations in the bond's value.
Given that all other inputs in the valuation models are identical, the difference in yield volatility assumptions will impact the calculated values for the call and put options in the two models.
Let's analyze the provided answer choices:
A. Davidson's model will calculate a lower value for the call option and a lower value for the putable bond.
If Davidson's model assumes a lower yield volatility (23%), it implies that the calculated value for the call option will be lower compared to Case's model. This is because lower volatility reduces the potential for large price movements in the underlying bond, which decreases the value of the call option.
Similarly, a lower yield volatility assumption will result in a lower value for the putable bond. A putable bond gives the bondholder the right to sell the bond back to the issuer at a predetermined price. When yield volatility is lower, there is less uncertainty about the future price of the bond, reducing the value of the put option embedded within the bond.
Therefore, answer choice A is correct.
B. Case's model will calculate a higher value for the call option and a lower value for the putable bond.
This answer choice is incorrect because it suggests that Case's model will calculate a higher value for the call option. However, since Case assumes a higher yield volatility (31%), the calculated value for the call option would actually be lower, not higher.
C. Davidson's model will calculate a lower value for the put option and a lower value for the callable bond.
This answer choice is incorrect because it states that Davidson's model will calculate a lower value for the put option. However, a lower yield volatility assumption in Davidson's model would result in a lower value for the put option, not a higher value.
To summarize, answer choice A accurately reflects the impact of different yield volatility assumptions on the valuation models. Davidson's model, with a lower yield volatility assumption, will calculate a lower value for the call option and a lower value for the putable bond compared to Case's model.