Effect of Volatility in Bonds With Embedded Options
A major factor affecting the value of a n option is expected volatility. The effect of volatility in bonds with embedded options shall be analyzed in two fold. First, for callable options, latter putable options.
The relationship is as follows: the greater the expected yield volatility, the greater the value of the option.
Price of callable bond = Price of option-free bond – Price of embedded call option.
If expected yield volatility increases, holding all other factors constant (ceteris paribus) the price of the embedded call option will increase. As a result the price of a callable bond will decrease.
Also the expected yield volatility affects the price of a putable bond,
Price of putable bond = price of option-free bond+ Price of embedded put option.
A decrease in expected yield volatility reduces the price of the embedded put option and therefore will decrease the price of a putable bond.