Question

A 7-year maturity convertible bond with a 8% annual coupon on a company with a bond rating of AAA is selling for $1,113. Each bond can be exchanged for 20 shares, and the stock price currently is $50 per share. Other AAA-rated bonds with the same maturity would sell at a yield to maturity of 9%. What is the value of the implicit call option on the bond? (Round your answer to 2 decimal places.) 5 of 6 points
Riskless profit	$
Why is the bond selling for more than the value of the shares it can be converted into? 1 of 6 points
The bond is worth more than the shares it can be converted into because the bond has ...........

Answer 1

First let us calculate the Value of the bond

Intrinsic value of the bond = Coupon * [ 1 - ( 1 + yield )^ -no of years ] / yield + principal * PVIFA ( r,n)

= 80 * [ 1 -1.09^-7] / 0.09 + 1000 /1.09^7

= 402.64 + 547.03 = 949.67

Price of convertible bond = Price of non convertible bond + call option

Call option value = Price of convertible bond - Price of non convertible bond = 1113 -949.67 = 163.33

The bond is worth more than the shares it can be converted into because the bond has call opton on the stock ie they can convert the bonds into stock when they want within the maturity period. So if a company performs well they can participate in the same through owning stocks.