Using the spot rates, what would be the value of an 8.5% option-free bond of this issuer?
What will be an ideal response?
The value of an 8.5% three-year option-free bond is the present value of the cash flows using the spot rates as the discount rates. Thus, using the one-year spot rates, the value of an 8.5% coupon option-free bond is given by:
option-free bond price = .
where the coupon payments per period (year) are C1 = C2 = C3 = $8.50 per $100 and the spot rates for years one, two and three are s1 = 7.50%, s2 = 7.6038%, and s3 = 7.7105%. Inserting in our coupon values and spot rate values and solving, we get:
option-free bond price = =
$7.90698 + $7.34114 + $86.82720 = $102.07532 or about $102.08 per $100 .
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