Chartered Financial Analyst (CFA) Practice Exam Level 2

How is the value of a call option (VCALL) calculated?

1. By subtracting the values of the bond and callable bond

2. By adding the values of the non-callable bond and the callable bond

3. By dividing the market price of the bond by its coupon rate

4. By adding the current yield to maturity and coupon rate

The correct answer is: By subtracting the values of the bond and callable bond

The value of a call option is determined by the intrinsic value that an investor would receive if they were to exercise the option. In the context of bonds, a callable bond includes the feature of a call option, which allows the issuer to redeem the bond before its maturity date at a specific price, usually at par. To find the value of a call option on a callable bond, one effective approach is to consider the value of the callable bond relative to that of a non-callable bond. The idea is that when an investor values the option to call, they recognize that the callable bond's value should be lower than the non-callable bond's value due to the potential for the issuer to call the bond, which limits upside potential for the bondholder. Thus, the value of the call option is calculated as the difference between the value of the non-callable bond (which represents the best-case scenario for an investor) and the value of the callable bond (which reflects the risk associated with the issuer potentially calling the bond). Therefore, subtracting the values of the callable bond from that of the non-callable bond correctly captures the value of the call option embedded in the callable bond. This approach effectively quantifies the option premium that an investor would