Answer: Either positive or negative convexity.

When the benchmark yield is high and the value of the embedded call option is low, callable and non-callable bonds exhibit similar responses to interest rate changes, both demonstrating positive convexity. However, as the benchmark yield decreases, the behavior of the bonds diverges. The callable bond transitions into a range of negative convexity, indicating that the embedded call option becomes more valuable to the issuer and increases the likelihood of it being exercised. This dynamic explains why callable bonds can exhibit either positive or negative convexity, depending on the prevailing yield environment.

Author: LeetQuiz Editorial Team