Question
A bond that was just issued by Standard Oil works as follows. The holder receives no coupon payment over the life of the bond. The
A bond that was just issued by Standard Oil works as follows. The holder receives no coupon payment over the life of the bond. The bond matures in one year. At the bond's maturity the company promised to pay $1,000 plus an additional amount based on the price of oil at that time. The additional amount was equal to the product of 170 and the excess (if any) of the price of a barrel of oil at maturity over $25.00. The maximum additional amount paid was $2,550 (corresponds to a price of $40 per barrel). Suppose that the call options on oil with strike price of $25 and maturity of one year are currently traded at $5.5, call options on oil with a strike price of $40 and maturity of one year are traded at $2.5. Suppose that the company is riskless and the 1-year zero rate is 2% per annum. What is the price of the bond? Show the details of your work and plot the payoff diagram of the bond.
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