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Question 2: Callable bond is the bond which gives an option to the issuer of such
bonds to call for redemption from investors before its maturity. In case issuer exercises
such an option, he will pay the premium to the bond owners. The option is exercised in
deckling interest scenario because fall in interest rates makes existing bonds more
expensive and firms can refinance the current debt at lower interest rates. The callable
prices 105 for the first bond and 110 for the other. Generally, a firm issue callable bonds
with an intention to call back and refinance the debt if the market rate of interest has
declined since the issue of the callable bonds. The reduction in market rate of interest
makes a callable bond costlier for the issuer. The chances of being called make the
callable bond riskier than the non-callable bond. Also, the bond with lower callable price
would higher yield to maturity. This is because the chances of being called a bond
higher if it’s callable –price is lower. Therefore, the bond callable at 105 will provide
more return than bond callable at 110 to it investors because of its lower price and all
other things like time to maturity and coupo...
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