Question

"A 7% general obligation bond is issued with 20 years to maturity. A customer buys the bond on a 7.50% basis. The bond contract allows the issuer to call the bonds in 5 years at 102 1/2, with the call premium declining by 1/2 point a year thereafter. The bond is puttable in 5 years at par. The price of the bond to a customer would be calculated based on the:"

Answer 1

The available options are:

A. 5 year call at 102 1/2

B. 5 year put at 100

C. 10 year call at 100

D. 20 year maturity

Answer:

20 year maturity

Step-by-step explanation:

Given that, the bond has a stated rate of interest of 7%, and at the same time, priced to yield 7.50%, this implies that, the bond is being sold at a discount.

The amount of the discount to which this equates is about $140 (this is depending on the figure). The dollar price of the bond would be $860 to yield 7.50% to maturity. Based on MSRB rules, it is ideal that, bonds are priced on a worst case basis, meaning in this case where the discount is $140, and it is earned over the longest period of time. This can only occurs if the bonds are held to maturity.

It should be noted that, If the bonds are called earlier, the yield actually improves on the bonds, since the customer earns the discount faster.

Hence, The price of the bond to a customer would be calculated based on the: 20 year maturity.