Calculate the price of a 5% coupon, $1000 face value 5 year bond that's callable after one year for $1030 if there's an equal chance that interest rates for each of the next five years will be 4%, 5% or 6% (in all cases, rates will be constant for all five years so either 4%, 4%, 4%, 4%, 4% or 5%, 5%, 5%, 5%, 5% or 6%, 6%, 6%, 6%, 6%).   Assume the call provision can only be exercised after the first coupon is paid (at the so called coupon anniversary).  If the probability that both 4% and 6% falls to 10% (leaving the average rate the same: 5%), the price of this bond will rise. Intuitively, explain why?

Answer rating: 100% (QA)

SOLUTION To calculate the price of the bond we need to calculate the present value of the bonds cash flows which consist of the coupon payments and th... View the full answer