Question

Which of the following statements is true?

i. Consider a non-callable corporate bond with a face value of $1,000, maturing in 5 years, and promising to pay 3% per year of interest. If the market price of the bond is $980, then the market price of an otherwise identical callable bond issued by the same corporation should be less than $980.
ii. There can be situations in which financial hedging actually reduces shareholder value, even if the transaction costs of hedging are zero.
a. I only.
b. II only.
c. I and II.
d. None.

Answer 1

Both statements about the corporate bond market price and financial hedging are true. Callable bonds are priced lower due to the redemption risk, and hedging can reduce shareholder value if it limits potential gains.

Step-by-step explanation:

In response to the student's question regarding corporate bonds, the following statements are evaluated:

• Statement I suggests that the market price of a callable bond should be less than a non-callable bond when all other factors are equal. This is typically true because callable bonds give the issuer the right to redeem the bond before maturity, which is an additional risk for the bondholder. Consequently, the market compensates for this risk by reducing the price of callable bonds compared to non-callable ones.
• Statement II mentions that financial hedging can reduce shareholder value even if transaction costs are zero. This can occur because hedging, while it reduces risk, may also limit the potential upside, potentially leading to lower returns. As such, if hedge instruments perform poorly compared to the unhedged position, the hedging can indeed reduce shareholder value.

Thus, both statements I and II can be considered true under the given circumstances, making the correct answer option 'c' - both I and II.

On the other hand, statement ii is also true. Financial hedging refers to strategies used to mitigate financial risks by taking offsetting positions in financial instruments. However, in certain situations, hedging can actually have unintended consequences and reduce shareholder value. This could happen if the costs of hedging outweigh the benefits or if the hedging strategy is not properly executed.