Question

Analysts estimate that a bond has an equal probability of being priced at either $940 or $1,050 one year from today. The bond is also callable at any time at $1,020. What is the expected value of this bond in one year? ASKED PREVIOUSLY - ANSWER WAS INCORRECT! Please show work.

Answer 1

Bonds expected price is either $940 or 1050. they have equal probability. it means each probability is 1/2=   0.5
One price=   $940
second price is $1050. but Bonds are callable at $1020. So if Bonds are priced at $1050, it means interest rate are lower. so company will call Bonds at $1020 and issue New Bonds at lower interest rate. So Bonds fair price in this case will be $1,020
  
Expected price =(value 1 *Probability)+(Value 2*probability)  
=(940*0.5)+(1020*0.5)  
=$980  
  
So expected price in year 1 is $980