A firm wishes to issue a perpetual callable bond.The current interest rate is 7%.Next year,the interest rate will be 6.5% or 8.25% with equal probability.The bond is callable at €1,075,and it will be called if the interest rate drops to 6.5%. What is the cost of the call provision to the firm if the bond sells for €1,000 today?

Question

Quizplus · Accepted Answer

The cost of the call provision is the difference between the price of the bond if it were not callable and the price of the callable bond. If the interest rate drops to 6.5%, the bond will be called at €1,075. The expected price of the bond without the call provision is the average of the bond prices at 6.5% and 8.25% interest rates. The cost of the call provision is calculated as €1,077.43 (expected price without call) - €1,000 (current price), which equals €77.43.

A Firm Wishes to Issue a Perpetual Callable Bond