Question

An 11% coupon callable bond with $100 par and maturing in 5 years is yielding 11.60%. The yield to call is 13.10%. The next call date is in 2 years at the call price of $101.90. What is the callable bond's call option premium?

a) $1.07
b) $2.12
c) $4.29
d) $1.52

Answer 1

The call option premium of a callable bond is the amount above the bond's par value that investors are compensated with due to the risk of early call. For an 11% callable bond with a call price of $101.90 and a par value of $100, the call premium is $1.90.

Step-by-step explanation:

To calculate the call option premium for an 11% coupon callable bond with a $100 par value, maturing in 5 years, and yielding 11.60%, with a call option in 2 years at a call price of $101.90, we need to understand the concept of yield.

The yield to call is the yield an investor would receive if the bond is called on the next call date, and in this case is 13.10%. This yield incorporates not just the coupon payments but also the capital gain or loss realized if the bond is called early at the call price of $101.90.

The call option premium can be thought of as the additional amount above the bond's par value that investors receive due to the callable feature of the bond. This premium is the compensation to the bondholder for the risk of the bond being called before maturity. Since the bond is callable at $101.90, which is above the par value of $100, the call option premium is the difference between these two prices, which is $1.90.