Sunday, August 30, 2009

Advantage and disadvantage of the call privilege

Clearly, the call privilege is an advantage to the security issuer because it grants him greater financial flexibility and the potential for reducing future interest costs. On the other hand, the call privilege is a distinct disadvantage to the security buyer, who may suffer a decline in the expected holding-period yield if the security is, in fact, called. The issuer will call in a security if the market rate of interest falls far enough so that the savings from issuing a new security at lower interest rates more than offset the call penalty plus flotation costs of a new security issue. This means, however, that an investor who is paid off will be forced to reinvest the call price in lower-yielding securities.
Another disadvantage for the investor is that call privileges limit the potential increase in a security‘s market price. In general, the market price of a security will not rise significantly above its call price, even when interest rates fall. The reason is that the issuer can call in a security at the call price, presenting the investor with a loss equal to the difference between the prevailing market price and the call price. Thus, callable securities have a more-limited potential for capital gains than non-callable securities.

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