Analysts estimate that one year from today,a bond has a probability of 40 percent of being priced at $950 and a probability of 60 percent of being priced at $1,050.The bond is also callable at any time at $1,010.What is the expected value of this bond in one year?
A)$995
B)$980
C)$1,000
D)$1,010
E)$986

Question

Quizplus · Accepted Answer

The expected value of the bond is given by:

Expected value = Probability of $950 * $950 price + Probability of $1,050 * $1,050 price + Probability of being called * $1,010 call price

Expected value = (0.4 * $950) + (0.6 * $1,050) + (0.6 * $1,010)

Expected value = $380 + $630 + $606

Expected value = $1,616

However, since the bond can only be worth between $950 and $1,050, we need to adjust the expected value to account for the call feature. If the bond is called, we know that it will be called at $1,010, so the expected value of the bond is capped at $1,010.

Therefore, the expected value of the bond is the minimum of $1,616 and $1,010, which is $986.

Therefore, the best choice is E.

Analysts Estimate That One Year from Today,a Bond Has a Probability