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.

The bond that would most likely protect investors against a significant increase in interest
rates is:
A. Bond #1.
B. Bond #2.
C. Bond #3.

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EXHIBIT 1 Fixed-Rate Bonds Issued by Pro Star, Inc. Coupon 4.40% annual 4.40% annual Bond Bond #1 Bond #2 Bond #3 Maturity 1 October 20X3 1 October 20X3 1 October 20X3 4.40% annual Type of Bond Option-free Callable at par on 1 October 20X1 and on 1 October 20X2 Putable at par on 1 October 20X1 and on 1 October 20X2