The theoretical value of a noncallable bond is $103; the theoretical value of a callable bond is $101 . Determine the theoretical value of the call option
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Effectively, the owner of a callable bond is entering into two separate transactions. First, the owner buys a noncallable bond from the issuer. Second, the owner sells the issuer a call option at a designated option price. The payment received lowers the value of the callable bond. Thus, in terms of price, a callable bond is generally speaking equal to the price of the two components parts that we can express as: callable bond price = noncallable bond price – call option price. Rearranging, we have: call option price = noncallable bond price – callable bond price. Inserting in our values, we have:
call option price = $103 – $102 = $2 .
In terms of a bond's par value of $1,000, the value of the call option is $20.00 .
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