If the market price of Pro Stars common stock falls from its level on 19 October 20X0,
Question:
If the market price of Pro Star’s common stock falls from its level on 19 October 20X0, the price of the convertible bond will most likely:
A. Fall at the same rate as Pro Star’s stock price.
B. Fall but at a slightly lower rate than Pro Star’s stock price.
C. Be unaffected until Pro Star’s stock price reaches the conversion price.
Samuel & Sons is a fixed-income specialty firm that offers advisory services to investment management companies. On 1 October 20X0, Steele Ferguson, a senior analyst at Samuel, is reviewing three fixed-rate bonds issued by a local firm, Pro Star, Inc. The three bonds, whose characteristics are given in Exhibit 1, carry the highest credit rating.
The one-year, two-year, and three-year par rates are 2.250%, 2.750%, and 3.100%, respectively. Based on an estimated interest rate volatility of 10%, Ferguson constructs the binomial interest rate tree shown in Exhibit 2.
On 19 October 20X0, Ferguson analyzes the convertible bond issued by Pro Star given in Exhibit 3. That day, the option-free value of Pro Star’s convertible bond is $1,060 and its stock price $37.50.
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