Question #43 - Reading 27 Valuation and Analysis of Bonds With Embedded Options

Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers

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Shared Context

- Which of the following statements is/are correct? Statement I: The straight bond should trade for less than $102. Statement II: If interest rate volatility were to increase then the price differential between the two Redna bonds would widen. A) Both statements are correct. B) Statement I is correct but Statement II is incorrect. C) Statement I is incorrect but Statement II is correct. Explanation The straight bond will be priced higher, as the investor will not have the risk of the bond being called. If interest rate volatility rises then the call option will become more valuable, and the price differential will widen. (Module 27.1, LOS 27.b)

Question

Suppose Redna were to issue a bond that was identical in all respects to the existing callable bond except that instead it was putable. How would a binomial tree valuation be adapted?

Answer Choices:

A. The put option becomes an effective floor price at each applicable node, instead of the call’s effective ceiling price

B. The put option becomes an effective floor price at each applicable node, as well as the call’s effective ceiling price

C. The put option becomes an effective ceiling price at each applicable node. Explanation A put option is an effective floor at each node. Call feature would no longer be relevant. (Module 27.2, LOS 27.f)

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