Question 1-10

One sided etr d embed nts One ped and a oat rate fr oater is rom in a fl to or oater minimum s an e straight rate bond. estor us, th eir price, which bonds res of common sh common stock that the b re e conversion price is adj issuances, and rights and warrants ensation when issuer pays divi given the opportunity to either put d at more advantageous terms in the help analyze and value convertible ond if it is converted at the market e bond sets a floor value for the or the strai ght value. This floor is The market conversion premium rlying shares if they buy the con the market price of the shares, it ible bond rather than the under- stocks, and options, as ble bond Converti prices but also the underlying hallenging bonds, including and callable convertible bond trades like a hybrid price of the instrument. PROBLEMS information relates to Questions 1-101 Thr following Samuel & Sons is a fixed-income specialty firm that offers advisory services to investment manage ment companies October 20x0, Steele Ferguson, a senior analyst at Samuel, viewing three fixed-rate bonds issued by a local firm, Pro Star, Inc. The three bonds, whose eristics a given in Exhibit 1, carry the highest credit rating. EXHIBIT Fixed-Rate Bonds Issued by Pro Star, Inc. Maturity Type of Bond 1 October 20X3 4.40% annual 1 October 20X3 Bond a2 40% annual e at par on 1 October 20x1 on 1 October 20x2 1 October 20X3 40% annual Bond 3 Putable at par on 1 october 20x on 1 October 20X2 The one-year, two-year, and three-year par rates are 2.250%, 2.750%, and 3.100%, re spectively. Based on an estimated interest rate volatility of 10%, Ferguson constructs th bino mial interest rate tree shown in Exhibit 2 EXHIBIT 2 Binom al Interest Rate Tree Year 1 Year 0 4.6470% 3.5930% 2.5000% 2.9417% 3.1150% question set was developed by Danny Hassett, CFA (Arlington, TX, USA) and loannis Georgiou CFA