Risk Capital Vs Asset Volatility

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Hi David,

2003 past year question
-a risky zero coupon bond maturing in one year
-Answer:
-the amount of risk capital required for this bond exhibits a hump shape - it first increases with asset volatility and then falls
-formula: price of risky bond = price of riskfree bond + put premium

My understanding on the formula :

Asset Volatility Put Premium Price of Risky Bond
High Increase Decrease
Low Decrease Increase

Then,
Why the risk capital is positively correlated with the Asset Volatility? Does the risk capital is inversely related with the price of risky bond i.e. price of risky bond decrease --- risk capital requirement increase and vice versa?

Your advice, please.

Regards
Learning

 

[David Harper CFA FRM]

Hi Learning,

We previously sort of picked apart that question here:
http://forum.bionicturtle.com/viewthread/1005/

David