Question

Determine the fair value of the following security on July 1^st, 2011. Show payoff graphs and all computations. Explain your solution as well in your own handwriting.

• The issuer is XYZ Company;
• The par value of this bond = U.S. Dollars 10 million;
• The coupon rate of this bond = 6 percent;
• The frequency of coupon payments is once per year, on June 30^th;
• The issuance date of this bond is on July 1^st, 2011; and
• The maturity date of this bond is on June 30^th, 2015 (4 years from issuance date).
• At maturity, the holder of this bond has the choice to receive the par value in cash or receive 500,000 common shares of XYZ Company. However, XYZ Company can payoff the bondholder at maturity cash amount of US$ 12.5 million instead of having to issue 500,000 common shares if the holder demands the latter.
• Investors in the market require 7 percent return on this bond on July 1^st, 2011.
• The common share price of XYZ Company on July 1^st, 2011 is U.S.$ 21.25;
• The standard deviation of the return on the common share of XYZ Company is 30 percent;
• The risk-free rate of return is 2.90 percent; and
• XYZ Company will not pay dividends over the next four years.

Answer 1