Question #85
Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers
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Question
Using the following binomial interest rate tree, calculate the value of a two-year, 2.5% putable bond. The American style embedded put option can be exercised anytime and has a strike price of 99. The value is closest to: 3.75% 3.175% 2.665%
Answer Choices:
A. 97.92
B. 99.00
C. 98.75. Explanation The putable bond price tree is as follows: A ==> 99.00 99.00 99.84 As an example, the price at node A is obtained as follows: PriceA = max[par value + coupon / (1 + rate), put price] = max[ (100 + 2.5) / (1 + 0.0375) ,99] = 99.00. The bond values at the other nodes are obtained in the same way. The calculated price at node 0 = [0.5(99.00 + 2.5) + 0.5(99.84 + 2.5)] / (1 + 0.03175) = $98.78 but since the put price is $99 the price of the bond will not go below $99. (Module 27.2, LOS 27.f)
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