An FI manager purchases a zero-coupon bond that has two years to maturity. The manager paid $76.95 per $100 for the bond. The current yield on a one-year bond of equal risk is 12 percent, and the one-year rate in one year is expected to be either 16.65 percent or 15.35 percent. Either rate is equally probable.
-Given the exercise price of the option, what premium should be paid for this option?
A)$0.2143 per $100 of bond option purchased.
B)$0.4420 per $100 of bond option purchased.
C)$1.2768 per $100 of bond option purchased.
D)$0.2321 per $100 of bond option purchased.
E)$1.1652 per $100 of bond option purchased.

Question

Quizplus · Accepted Answer

The premium is calculated using the expected future interest rates and the bond's price. The expected future interest rate is the average of the two possible rates (16.65% and 15.35%), which is 16%. The bond's price is calculated using the current yield and the expected future rate. The difference between the bond's price and the exercise price gives the option premium.

An FI Manager Purchases a Zero-Coupon Bond That Has Two