The Following Information Relates to Questions 20-27John Smith, an Investment

question 24

Multiple Choice

The following information relates to Questions 20-27John Smith, an investment adviser, meets with lydia Carter to discuss her pending retirement
and potential changes to her investment portfolio. domestic economic activity has been weak-ening recently, and Smith's outlook is that equity market values will be lower during the next year. He would like Carter to consider reducing her equity exposure in favor of adding more fixed-income securities to the portfolio.Government yields have remained low for an extended period, and Smith suggests con-sidering investment-grade corporate bonds to provide additional yield above government debt issues. in light of recent poor employment figures and two consecutive quarters of negative GdP growth, the consensus forecast among economists is that the central bank, at its next meeting this month, will take actions that will lead to lower interest rates.
Smith and Carter review par, spot, and one-year forward rates (Exhibit 1) and four fixed- rate investment-grade bonds issued by Alpha Corporation that are being considered for invest-ment (Exhibit 2) .
$$\begin{array}{l}\text { EXHIBTT } 1 \text { Par, Spot, and One-Year Forward Rates (annual coupon payments) }\\\begin{array} { l c c c } \hline \text { Maturity (Years) } & \text { Par Rate (\%) } & \text { Spot Rate (\%) } & \text { One-Year Forward (\%) } \\\hline 1 & 1.0000 & 1.0000 & 1.0000 \\2 & 1.2000 & 1.2012 & 1.4028 \\3 & 1.2500 & 1.2515 & 1.3522 \\\hline\end{array}\end{array}$$
EXHIBIT 2 Selected Fixed-Rate Bonds of Alpha Corporation
$\begin{array}{lcl}\hline \text { Bond } & \text { Annual Coupon } & \text { Type of Bond } \\\hline \text { Bond 1 } & 1.5500 \% & \text { Straight bond } \\\text { Bond 2 } & 1.5500 \% & \text { Convertible bond: currently trading out of the money } \\\text { Bond 3 } & 1.5500 \% & \text { Putable bond: putable at par one year and two years from now } \\\text { Bond 4 } & 1.5500 \% & \text { Callable bond: callable at par without any lockout periods }\\\hline\end{array}$
Note: All bonds in Exhibit 2 have remaining maturities of exactly three years.
Carter tells Smith that the local news media have been reporting that housing starts,exports, and demand for consumer credit are all relatively strong, even in light of other poor macroeconomic indicators. Smith explains that the divergence in economic data leads him to believe that volatility in interest rates will increase. Smith also states that he recently read a report issued by Brown and Company forecasting that the yield curve could invert within the next six months. Smith develops a binomial interest rate tree with a 15% interest rate volatility assumption to assess the value of Alpha Corporation's bonds. Exhibit 3 presents the interest rate tree.

Carter asks Smith about the possibility of nalyzing bonds that have lower credit rat-ings than the investment-grade Alpha bonds. Smith discusses four other corporate bonds with Carter. Exhibit 4 presents selected data on the four bonds. EXHiBiT 4 Selected information on fixed-Rate Bonds for Beta, Gamma, delta, and Rho
$\text { Corporations }$
$\begin{array}{lllc}\hline\text { Bond } & \text { Issuer } & \text { Bond Features } & \text { Credit Rating } \\\hline \text { Bond 5 } & \text { Beta Corporation } & \text { Coupon 1.70\% } & \text { B } \\& & \text { Callable in Year 2 } & \\& &\text { OAS of } 45 \text { bps } & \\\text { Bond 6 } & \text { Gamma Corporation } & \text { Coupon 1.70\% } \\& & \text { Callable in Year 2 } & \\&& \text { OAS of 65 bps } \\\text { Bond 7 } & \text { Delta Corporation } & \text { Coupon 1.70\% }&\text { B }\\ & & \text { Callable in Year 2 } & \\& & \text { OAS of } 85\\\text { Bond 8 }& \text { Rho Corporation } & \text { Coupon 1.70\% } & \text { CCC } \\&&\text {Callable in Year 2}\\&&\text {OAS of \( 105 \mathrm{bps} \) }\\\hline\end{array}$
Notes: All bonds have remaining maturities of three years. oAS stands for option-adjusted spread.
-Based on Exhibit 2, and assuming that the forecast for interest rates and Smith's outlook for equity returns are validated, which bond's option is most likely to be exercised?

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