In a rising interest rate environment, the difference in effective duration between a callable bond and a non-callable bond would most likely:
- increase.
- decrease.
- remain unchanged.
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B is correct. As interest rates rise, the call option is less likely to be exercised by the issuer, so the difference in effective duration between a callable bond and a non-callable bond is expected to narrow (decrease). The reverse is true in a falling interest rate environment, because the call option is more likely to be exercised and will have the effect of reducing the effective duration of a callable bond and widening (increasing) the difference in effective duration with a non-callable bond (see Exhibit 8 of reading).
A and C are incorrect. Effective durations for a callable bond and a non-callable bond are very similar when benchmark yields are high, because the embedded call option is unlikely to be exercised. As yields increase, any difference in effective duration between a callable bond and a non-callable bond will decrease.