Neues Geschaft, Inc., has an outstanding perpetual bond with a 10% coupon rate that can be called in one year. The bonds make annual coupon payments.
The call premium is set at $150 over par value. There is a 40% chance that the interest rate in one year will be 12%, and a 60% chance that the interest rate will be 7%. If the current interest rate is 10%, what is the current market price of the bond?
The price of the bond today would be the present value of the cash flows from the bond.
We estimate the cash flows at the end of 1 year for the bond holders and then use these to calculate the price today.
If the interest rate in one year is 12%, the bonds would not be called as the price would be lower than the call ...
The solution explains how to calculate the current market price of the bond