Explain why you agree or disagree with the following statement: "An investor should be unwilling to pay more than the call price for a bond that is likely to be called."

What will be an ideal response?

As shown below, one would disagree with the statement.

Consider a callable bond with a 10-year 13% coupon rate that is callable in one year at a call price of 104 . Suppose that the yield on 10-year bonds is 6% and that the yield on one-year bonds is 5%. In a 6% interest-rate environment for 10-year bonds, investors will expect that the issue will be called in one year. Thus investors will treat this issue as if it is a one-year bond and price it accordingly. The price must reflect the fact that the investor will receive a 13% coupon rate for one year. The price of this bond would be the present value of the two cash flows, which are
(i) $6.50 (per $100 of par value) of coupon interest six months from now, and (ii) $6.50 coupon interest plus the call price of $104 one year from now. Discounting the two cash flows at the 5% prevailing market yield (2.5% every six months) for one-year bonds, the price is

= $111.52.

The price is greater than the call price. Consequently, an investor will be willing to pay a higher price than the call price to purchase this bond. Thus, one would not agree with the statement: "An investor should be unwilling to pay more than the call price for a bond that is likely to be called."