Suppose that the Johnson family has the option of purchasing two bonds. • Bond A

Question

Suppose that the Johnson family has the option of purchasing two bonds.

• Bond A is a $4000 10% 10 year bond paying annual coupons with redemption value $2000, which can be purchased at a premium for $3000.

• Bond B is a $4000 10% 10 year bond paying annual coupons with redemption value $3000, which can be purchased at a discount for $2000.

Suppose further that each bond has a lockout period of 5 years, after which a put option can be placed at the end of years {6, 7, 8, 9} for put premium of $1500.

Compile a technical report to explain to the Johnson family which bond option you would recommend, and at which time (if any) they should exercise their put option.

-Background remarks

-Thorough analysis of the Bond options available

-Make a decision for Johnson family and explain reasoning

Explanation / Answer

Ans;

Bond B would be recommended.

In the given question, Face value, Redemption period & interest rate of Bond A and Bond B are same. The difference is w.r.t purchase value and redeemable value which are favour for Bond B with low purchase value and High redeemable value when compared to Bond A.

Also see the 2nd condition. Lets suppose redeem Bond A at the end of 6th year which gives $1500.So, interest on Bond A in outside market assuming 10% is $150. But Bond B continues to gives you inetrest @ 10% on $4000 which is $400. It seems opportunity cost of Bond A is also lower than Bond B.

Hence purchase of Bond B is recommended.

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