Pricing bond options (online classroom example)

[VSA_88]

Hi
I'm am little stuck on pricing the acted bond option question. The question is a section in Online Classroom. The issue I have is not understanding when the coupons are paid for bonds with fractional years.

The question states that the term of the bond is 4.25 years with annual coupons payable. By looking at the answer it would seem that the coupons are paid at times 0.25, 1.25, 2.25, 3.25 and 4.25. Can someone confirm that my understanding is correct here? Do you always start from the final term and work out the coupon payment dates from that i.e. going backwards from final payment date?

 

[Joe Hook]

Hi,

Your understanding is correct here. Questions in SP5 can sometimes be a little vague in terms of a basis. It would be reasonable however to assume that a bond with annual coupons will pay those coupons at the end of each year which in this case would be times 0.25, 1.25, 2.25, 3.25 and 4.25. Your idea of working backwards from maturity, when the last coupon would be paid, is a good idea!

Joe

 

[VSA_88]

Thanks Joe. I'd hope that you'd still get well rewarded marking wise if you clearly stated what you're assuming and that's not what the examiner wanted. As I get closer to full exam practice, I'll keep an eye on the examiner's comments.

 

[Joe Hook]

That's a good idea and indeed you would hope so. When it comes to making assumptions the other thing to look out for is that you're not overly simplifying the question. In this case I don't think you would be necessarily but it's good to try to tie up with exactly what the examiner is looking for if you can. Good luck!