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solution

  1. Northeastern Bank has issued 5-year zero coupon bonds that has an unusual feature. The face value of the bonds at maturity depends on the price of the company’s stock price (ST) at maturity. The specific formula is:

Share price at maturity of bonds in five years (ST)

Payment to Bond holders at Maturity (T = 5)

ST < 40.0

ST

40.0 = ST = 45.0

40.0

45.0 < ST

40.0 + (ST – 45.0)

Assume that the stock price S0 (at the time the bonds are issued) is $40.0. The Call and Put option prices for their respective strikes are given below.

Exercise Price

Price of Call

Price of Put

40.0

20

10

45.0

18

14

  1. Draw a graph (not necessarily to scale) showing the payoff to the bondholders at maturity (Y-Axis) with St on the X-Axis. Clearly mark important values on the axes.
  2. Find the Price of each bond issued by Northeastern Bank (The above graph should help you). Show or Upload a file with your work.

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