Two bonds have the following terms:Bond APrincipal ………$1,000Coupon ………8%Maturity ………10 yearsBond...

Question

Two bonds have the following terms:Bond APrincipal ………$1,000Coupon ………8%Maturity ………10 yearsBond BPrincipal ………$1,000Coupon ………7.6%Maturity ………10 yearsBond B has an additional feature: It may be redeemed at par after five years (i.e., it has a put feature). Both bonds were initially sold for their face amounts (i.e., $1,000).a) If interest rates fall to 7 percent, what will be the price of each bond?b) If interest rates rise to 9 percent, what will be the decline in the price of each bond from its initial price?c) Given your answers to questions (a) and (b), what is the trade-off implied by the put option in bond B?d) Bond B requires the investor to forgo $4 a year (i.e., $40 if the bond is in existence for ten years). If interest rates are 8 percent, what is the present value of this forgone interest? If the bond had lacked the put feature but had a coupon of 7.6 percent and a term to maturity of ten years, it would sell for $973.16 when interest rates were 8 percent. What, then, is the implied cost of the put option?

David · Accepted Answer

a. Compute the present value of bonds at 7% in the following manner: 
Price of Bond A= [
      
      
] + [
      
      
]+…..+ [
      
      
] + [
          
      
] 
Coupon= 0.08* 1000= $80
Interest rate, i= 7% 
Maturity, n= 10 years 
Price of bond A=  [
  
        
] + [
  
        
]+…..+ [
  
         
] + [
    
         
] 
Price of bond A= $1069.92
Price of bond B= [
      
      
] + [
      
      
]+…..+ [
      
      
] + [
          
      
] 
Coupon= 0.076*1000= $76 
Interest rate, i= 7% 
Maturity, n= 10 years 
Price of bond B=  [
  
        
] + [
  
        
]+…..+ [
  
         
] + [
    
         
] 
Price of Bond B= $1041.82
b. Compute the price of bonds at 9% interest rate: 
Price of Bond A= [
      
      
] + [
      
      
]+…..+ [
      
      
] + [
          
      
] 
Coupon= 0.08* 1000= $80 
Interest rate, i= 9% 
Maturity, n= 10 years 
Price of bond A=  [
  
        
] + [
  
        
]+…..

Two bonds have the following terms: Bond A Principal ………$1,000 Coupon ………8% Maturity ………10 years Bond B Principal ………$1,000 Coupon ………7.6% Maturity ………10 years Bond B has an additional feature: It may...

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