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%. If the coupon were set to $70 what would the bond sell for?
A) $824.61.
B) $898.82.
C) $964.25.
D) $1000.00.
E) $1031.74.

Question

Quizplus · Accepted Answer

The bond will be called if the interest rate drops to 6.5%, so the bondholder will receive $1,075. If the interest rate rises to 8.25%, the bond will not be called, and the bondholder will receive $70 annually. The expected value of the bond is the average of these two scenarios, discounted at the current interest rate of 7%. Calculating this gives a bond price of approximately $964.25.

A Firm Wishes to Issue a Perpetual Callable Bond