Bonds issued by the XYZ Corp. are currently callable at par value and trade close to par. The bonds mature in 8 years and have a coupon of 8%. The yield on the XYZ bonds is 175 basis points over 8-year US Treasury securities, and the Treasury spot yield curve has a normal, rising shape. If the yield on bonds comparable to the XYZ bond decreases sharply, the XYZ bonds will most likely exhibit:
A. Negative convexity
B. Increasing modified duration
C. Increasing effective duration
D. Positive convexity
Answer:A
As yields in the market declines, the probability that the call option will get exercised increases. This causes the price to reduce relative to an otherwise comparable option free bond, which is also known as a negative convexity.