The Following Information Relates to Questions 1-10
Samuel & Sons

question 26

Multiple Choice

The following information relates to Questions 1-10
Samuel & Sons is a fixed-income specialty firm that offers advisory services to investment management companies. on 1 october 20X0, Steele ferguson, a senior analyst at Samuel, is reviewing three fixed-rate bonds issued by a local firm, Pro Star, inc. The three bonds, whose characteristics are given in Exhibit 1, carry the highest credit rating.
EXHiBiT 1 fixed-Rate Bonds issued by Pro Star, inc.
$\begin{array}{lcll}\text { Bond } & \text { Maturity } & \text { Coupon } &{\text { Type of Bond }} \\\hline \text { Bond 1 } & 1 \text { October 20X3 } & 4.40 \% \text { annual } & \text { Option-free } \\\\\text { Bond 2 } & 1 \text { October 20X3 } & 4.40 \% \text { annual } & \text { Callable at par on 1 October 20X1 } \\&&&\text { and on 1 October 20X2 } \begin{array}{l}\\\end{array} \\\text { Bond 3 } & \text { 1 October 20X3 } & 4.40 \% \text { annual } & \text { Putable at par on 1 October 20X1 } \\ &&&\text { and on 1 October 20X2 }\end{array}$
The one-year, two-year, and three-year par rates are 2.250%, 2.750%, and 3.100%, re-spectively. Based on an estimated interest rate volatility of 10%, ferguson constructs the bino-mial interest rate tree shown in Exhibit 2.
EXHiBiT 2 Binomial interest Rate Tree
on 19 october 20X0, ferguson analyzes the convertible bond issued by Pro Star given in Exhibit 3. That day, the option-free value of Pro Star's convertible bond is $1,060 and Pro Star's stock price is $37.50.
EXHiBiT 3 Convertible Bond issued by Pro Star, inc.
$\begin{array} { l c } \text { Issue Date: } & 6 \text { December 20X0 } \\\hline \text { Maturity Date: } & 6 \text { December 20X4 } \\\text { Coupon Rate: } & 2 \% \\\text { Issue Price: } & \$ 1,000 \\\text { Conversion Ratio: } & 31\\\hline\end{array}$
-All else being equal, if the shape of the yield curve changes from upward sloping to flat- tening, the value of the option embedded in Bond 2 will most likely:

• A) decrease.
• B) remain unchanged.
• C) increase.

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