The Following Information Relates to Questions 11-19
Rayes Investment Advisers

question 25

Multiple Choice

The following information relates to Questions 11-19
Rayes investment Advisers specializes in fixed-income portfolio management. Meg Rayes, the owner of the firm, would like to add bonds with embedded options to the firm's bond port-folio. Rayes has asked Mingfang Hsu, one of the firm's analysts, to assist her in selecting and analyzing bonds for possible inclusion in the firm's bond portfolio.Hsu first selects two corporate bonds that are callable at par and have the same character-istics in terms of maturity, credit quality and call dates. Hsu uses the option-adjusted spread(oAS) approach to analyse the bonds, assuming an interest rate volatility of 10%. The resultsof his analysis are presented in Exhibit 1.
EXHIBIT 1 Summary Results of Hsu's Analysis Using the OAS Approach
$\begin{array}{l}\text { Analysis Using the OAS Approach }\\\begin{array}{lc}\hline \text { Bond } & \text { OAS (in bps) } \\\hline \text { Bond 1 } & 25.5 \\\text { Bond 2 } & 30.3 \\\hline\end{array}\end{array}$

Hsu then selects the four bonds issued by Rw, inc. given in Exhibit 2. These bonds all have a maturity of three years and the same credit rating. Bonds 4 and 5 are identical to Bond3, an option-free bond, except that they each include an embedded option.
$$\begin{array}{l}\text { EXHIBIT } 2 \text { Bonds Issued by RW, Inc. }\\\begin{array} { l l l } \hline \text { Bond } &{ \text { Coupon } } & { \text { Special Provision } } \\\hline \text { Bond } 3 & 4.00 \% \text { annual } & \\\text { Bond } 4 & 4.00 \% \text { annual } & \text { Callable at par at the end of years } 1 \text { and } 2 \\\text { Bond } 5 & 4.00 \% \text { annual } & \text { Putable at par at the end of years } 1 \text { and } 2 \\\text { Bond } 6 & \text { One-year Libor annually, } \\&\text { set in arrears }\\\hline\end{array}\end{array}$$
To value and analyze Rw's bonds, Hsu uses an estimated interest rate volatility of 15% and constructs the binomial interest rate tree provided in Exhibit 3.

Rayes asks Hsu to determine the sensitivity of Bond 4's price to a 20 bps parallel shift ofthe benchmark yield curve. The results of Hsu's calculations are shown in Exhibit 4.EXHiBiT 4 Summary Results of Hsu's Analysis about the Sensitivity of Bond 4's Price to a ParallelShift of the Benchmark yield Curve Magnitude of the Parallel Shift in the Benchmark yield Curve +20 bps −20 bps full Price of Bond 4 (% of par) 100.478 101.238 Hsu also selects the two floating-rate bonds issued by Varlep, plc given in Exhibit 5. These
bonds have a maturity of three years and the same credit rating.
$$\begin{array}{l}\text { EXHIBIT } 5 \text { Floating-Rate Bonds Issued by Varlep, plc }\\\begin{array} { l l } \text { Bond } & \text { Coupon } \\\hline \text { Bond } 7 & \text { One-year Libor annually, set in arrears, capped at } 5.00 \% \\\text { Bond } 8 & \text { One-year Libor annually, set in arrears, floored at } 3.50 \% \\\hline\end{array}\end{array}$$
To value Varlep's bonds, Hsu constructs the binomial interest rate tree provided inExhibit 6.

last, Hsu selects the two bonds issued by whorton, inc. given in Exhibit 7. These bonds are close to their maturity date and are identical, except that Bond 9 includes a conversion option. whorton's common stock is currently trading at $30 per share.
$$\begin{array}{l}\text { EXHІВАТ } 7 \text { Bonds Issued by Whorton, Inc. }\\\begin{array} { l l } \text { Bond } & \text { Type of Bond } \\\hline \text { Bond } 9 & \text { Convertible bond with a conversion price of } \$ 50 \\\text { Bond } 10 & \text { Identical to Bond } 9 \text { except that it does not include a conversion option } \\\hline\end{array}\end{array}$$
-in Exhibit 2, the bond whose effective duration will lengthen if interest rates rise is:

• A) Bond 3.
• B) Bond 4.
• C) Bond 5.

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