Financial Industry Regulatory Authority (FINRA) Practice Exam

When considering call risk, especially in a falling interest rate environment, callable bonds become a focal point. Callable bonds give the issuer the right to redeem the bond before its maturity date at a specified call price. This feature is particularly significant when interest rates decrease because issuers can refinance their debt more cheaply by calling higher coupon bonds and issuing new bonds at lower interest rates. Callable bonds with higher coupons are especially susceptible to this risk. When interest rates fall, these bonds become more attractive to investors due to their higher coupon payments compared to newly issued bonds. Consequently, the issuer is more likely to execute the call option to replace these costly bonds with new debt at a lower interest rate. This potential loss of the bond when it is called leads to call risk for the holders. In contrast, callable bonds with lower coupons are less attractive in a falling interest rate environment, as their yield does not significantly exceed the new lower rates, making it less likely for an issuer to call them. Non-callable bonds inherently do not face call risk since they lack the feature that allows the issuer to redeem them early. All bonds, in general, cannot be considered equally likely to expose holders to call risk in this context. Therefore, the focus on callable bonds with higher coupons correctly