Question

A $1,000 face value bond can be redeemed early at the issuer's discretion for $1,030, plus any accrued interest. The additional $30 is called which one of the following?

1) dirty price
2) redemption value
3) call premium
4) original-issue discount
5) redemption discount

Answer 1

The additional $30 paid on top of the face value for early bond redemption is known as the call premium. This premium compensates bondholders when redemption occurs before the bond's maturity due to changing market conditions and interest rates.

Step-by-step explanation:

The additional $30 paid above the face value of the $1,000 bond is called a call premium. This call premium compensates the bondholder for early redemption of the bond at the issuer's discretion before its maturity date. When considering the risk of the bond, if market interest rates rise, the bond becomes less attractive, since new bonds would likely offer higher interest rates. To make the bond more appealing, the price would need to be lowered. If the interest rate on a bond is below market rates, and with one year left to maturity, the bond's price will be calculated in a way that the present value of its expected payments ($1,080 from final interest plus principal repayment) matches the current market conditions, taking into account the alternative investment options available at the prevailing rate, which is here given as 12%.