Dear :

why use the call price if the call price is less than the discount value in the example below.

thank you so much for your time.

A callable bond with an 8.2% annual coupon will mature in two years at par value. The current one-year spot rate is 7.9%. For the second year, the yield-volatility model forecasts that the one-year rate will be either 6.8% or 7.6%. The call price is 101. Using a binomial interest rate tree, what is the current price?

**A)**

100.558.

**B)**

101.000.

**C)**

100.279.

**Your answer: A was incorrect. The correct answer was B)** 101.000.

The tree will have three nodal periods: 0, 1, and 2. The goal is to find the value at node 0. We know the value for all the nodes in nodal period 2: V_{2}=100. In nodal period 1, there will be two possible prices:

V_{1,U} =[(100+8.2)/1.076+(100+8.2)/1.076]/2 = 100.558

V_{1,L} =[(100+8.2)/1.068+(100+8.2)/1.068]/2= 101.311

Since V_{1,L} is greater than the call price, the call price is entered into the formula below:

V_{0}=[(100.558+8.2)/1.079)+(101+8.2)/1.079)]/2 = 101.000.