The on-the-run issue for ABC Company is shown below: Maturity 123 Yield to maturity Market price 7.50% 100 7.60% 100 7.70% 100 Using the bootstrapping methodology, the spot rates are: Spot rate Maturity 7.50% 1 2 3 Assuming an

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The on-the-run issue for ABC Company is shown below: Maturity 123 Yield to maturity Market price 7.50% 100 7.60% 100 7.70% 100 Using the bootstrapping methodology, the spot rates are: Spot rate Maturity 7.50% 1 2 3 Assuming an interest rate volatility of 10% for the 1-year rate, the binomial interest rate tree for valuing a bond with maturity of up to three years is shown below: 8.481% 7.50% 7.604% 7.71% 6.944% 9.603% 7.862% 6.437% I a) Demonstrate using the 3-year on-the-run issue that the binomial interest rate tree above is in fact an arbitrage free tree. b) Consider a 2-year on-the-run issue, demonstrate that the binomial interest rate tree above is also an arbitrage free tree c) Using the spot rate given above, what is the arbitrage-free value of a 3-year 8.5% coupon issue of ABC Company d) Using the binomial tree, determine the value of an 8.5% 3-year option free- bond e) Suppose that the 3-year 8.5% is callable starting in year 1 at par (100). What is the value of this 3-year 8.5% coupon callable bond? f) What is the value of embedded call option for the 3-year 8.5 % callable issue?

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