Question #63 - 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

- Compute V0, the value of the bond at node 0. A) $104.76. B) $99.07. C) $101.35. Explanation V0 = (½)[(V1U + C) / (1 + r0)] + [(V1L + C) / (1 + r0)] From the previous question the value for V1U was determined to be $99.127 V0 = (½)[(99.127 + 8) / (1 + 0.043912)] + [(103.583 + 8)/(1 + 0.043912)] = $104.755 (Module 27.2, LOS 27.f)

Question

Assume that the bond is putable in one year at par ($100) and that the put will be exercised if the computed value is less than par. What is the value of the putable bond?

Answer Choices:

A. $103.04

B. $95.38

C. $105.17. Explanation The relevant value to be discounted using a binomial model and backward induction methodology for a putable bond is the value that will be received if the put option is exercised or the computed value, whichever is greater. In this case, the relevant value at node 1U is the exercise price ($100.000) since it is greater than the computed value of $99.127. At node 1L, the computed value of $103.583 must be used. Therefore, the value of the putable bond is: V0 = (½)[(100.00 + 8) / (1 + 0.043912)] + [(103.583 + 8) / (1 + 0.043912)] = $105.17314 (Module 27.2, LOS 27.f)

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