Independent Case B

The spot rate for the first year, the forward rate for the second year, and the forward rate for third year are 5.2%, 5.4%, and 5.5%, respectively.

1. What must be the price of a three-year Government of Canada 6% annual coupon bond?
2. A corporate bond has a $1000 face value, 3 years to maturity, and a 5% annual coupon. This bond is retractable (puttable) only at two times: at the end of year 1 for $975, and at the end of year 2 for $990. These bonds trade at a 2% yield spread to the stated term structure, and issue costs are minimal and can be ignored. Applying the PEH, when, if ever, would you expect the bondholders to put the bond back to the corporation?

Hint: You will need to determine the expected value of the bond based on the coupon payments and the appropriate forward rates at each of the retraction dates.