Final answer:
The make-whole call provision means that the call price of a bond is calculated to cover the present value of the bond's future cash flows. The call price is directly related to the market rate of interest, as lower rates increase the present value and the call price, while higher rates decrease it.
Step-by-step explanation:
When a bond has a make-whole call provision, it means that if the bond is called (redeemed before its maturity), the issuer must make the bondholder whole by paying a call price that compensates for the interest payments that the bondholder will miss out on. The call price is typically determined by a formula taking into account the present value of the remaining coupon payments and the principal to be repaid at maturity, discounted at a specified spread above a reference rate or the treasury rate. Therefore, the call price is not necessarily directly or inversely related to the market rate of interest as it depends on the specific terms of the bond's make-whole call provision. This provision is a way for the bond issuer to retire the debt early if it is beneficial to do so, such as when interest rates have declined substantially.
The correct answer to the student's question is that the call price is directly related to the market rate of interest. This is because lower market interest rates generally result in a higher present value of future cash flows, thus increasing the call price. Conversely, if market interest rates rise, the present value of future cash flows decreases, leading to a lower call price.