Question #54

of 98 Bill Moxley, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of his pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. The yield curve is currently flat. If the yield curve becomes upward sloping, the bond least likely to have the highest price impact would be: A) Bond B B) Bond A C) Bond C Explanation Bond C is putable and hence has limited downside potential when rates rise. The other two bonds do not have any such protection. (Module 27.3, LOS 27.e) Company Isla has a four-year, 6.5% bond that is callable under the following schedule: 102 in one year's time 101 in two years' time 100 in three years' time The binomial interest rate assuming a 10% rate volatility is shown in Exhibit 1. At each of the nodes: F = the value of the bond obtained by applying the backward induction process (i.e., the expected PV of future cash flows from the bond) C = the coupon received at the time of the node V = For the call price depending on whether or not the company is likely to call the bond Exhibit 1: Binomial Interest Rate Tree