QUESTION $2$

ABC plc plans to issue bonds with a face value of $10,000$ each, coupon rate of $4$

percent, paid annually, and $10$ years to maturity. The current market interest rate on

similar bonds is $4$ percent.

In one years$$ time, the long$-$term interest rate for this type of bond is predicted to be

either $5$ percent or $3$ percent with equal probability. Assume investors are risk$-$neutral.

Required:

a$)$ If the bonds are non$-$callable, what is the price of the bonds today,

taking into account only the current market interest rate on similar

bonds? Explain your answer.

$(3$ marks$)$

b$)$ If the bonds are non$-$callable, what is the price of the bonds today,

taking into account both the current market interest rates and the

long$-$term interest rates after one year?

$(9$ marks$)$

c$)$ What is the current yield of the bond for a bondholder based on the

value you computed in $($b$)$ above?

$(2$ marks$)$

d$)$ If the bonds are callable one year from today at $110$ per cent of the

face value, will their price be greater than or less than the price you

computed in $($b$)?$ Explain your answer.

$(4$ marks$)$

e$)$ Why would a firm choose to issue callable bonds? $(4$ marks$)$

f$)$ In an efficient market, would callable bonds be priced higher or lower

than the non$-$callable bonds, other things being equal? Explain your

answer.

$(6$ marks$)$

g$)$ Why do investors pay attention to bond ratings and demand a

higher interest rate for bonds with lower rating? What does lower

rating imply in terms of credit risk?

$(2$ marks$)$

$($Total marks $30)$