Suppose a bond with a par value of $1000 pays an annual coupon payment of $100. Interest rates are currently at 7% for all maturities of the same default risk as this bond. The bond has 10 years until maturity but is callable beginning in 2 years at a $75 call premium (that is, for $1075.00).
a. If interest rates remain the same, would you expect the bond to be called in 2 years?
b. Given your answer in (a), what would be the current market price of this bond?
c. What level of interest rates would make the firm indifferent between calling the bond and having it remain outstanding?
a. The issuer of the bonds has an option to call the bond before it matures, for which it pays in the form of a higher coupon rate. This is the reason why this bonds coupon rate is 10% while the market rate is only 7%. ...
This solution demonstrates to students how to use interest rates to determine whether a bond will be called within the call period. It also shows how to calculate the current market price on a callable bond, and the interest rate that would make the firm indifferent about calling the bond or allowing it to remain outstanding.