Question

8.3 Assume that you are thinking of buying a default-free bond.

Specifically, you’re thinking of buying a bond issued by Risklessco, a company that is considered default-free by all major bond rating firms. You will select one of the following three bonds, which are identical except for the special features listed.

Bond	Face Value	Maturity	Coupon rate (paid annually)	Yield to Maturity*	Special features	Price
A	1000	20 years	5.5%	5%	None	?
B	1000	20 years	5.5%	5%	Callable	Par
C	1000	20 years	5.5%	3.5%	Callable and convertible into Risklessco stock	?

* Yield to maturity represents the market’s required rate of return. It is calculated using only stated coupon payments and face value, without regard for the special features.

a. Bond B is considered identical to Bond A except for the callability provision. (4 marks, 1 each)

i. What would be the price of Bond A?

ii. What is the implied value of the callability provision?

iii. Who does the callability provision benefit: the issuer or the purchaser?

iv. Is this consistent with the price you calculated for Bond A relative to the price of Bond B? Briefly explain.

b. Bond C is considered identical to bond B except for the conversion privilege. (4 marks, 1 each)

i. What would be the price of Bond C?

ii. What is the implied value of the conversion privilege?

iii. Does the conversion privilege benefit the issuer or the purchaser of the bond?

iv. Is this consistent with the price you calculated for Bond C relative to the price of Bond B? Briefly explain.

Answer 1