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Question 2 (20 Marks) (A) When the issuer exercising the call option of the callable bond, the callable bond will be redeemed at Call Price. (i) What impact does it have on the investors rate of return for the period from the purchase of the bond to its call? (3 Marks) (ii) What impact does it have on the investors rate of return for the period from the purchase of the bond to the bond investors original investment horizon period?

(3 Marks) (B) From the issuers perspectives, explain the relationship between call risk premiums and the level of interest rates in the economy. (6 Marks) On June 1, 1989, a bond portfolio manager is evaluating the following data concerning 3 bonds held in portfolio. Bond Rating Coupon Maturity Call Price (Date) Market Price YTM Modified Duration

Change in Market Price X AA 0% 8/14/2014 Noncall 59.44 10.25% 5.2 years +5.1% Y AA 14% 3/30/2018 Noncall 116.60 11.00% 5.2 years +5.5% Z AA 10.25% 7/15/2017 100 (6/1/2010) 98.63 10.50% 5.2 years +2.4% It is noted that all 3 bonds have the same modified duration and thus are expected to rise in price by 5.2% for a 100 basis point decline in interest rates. However, the data from the above table shows that a different change in price occurs for each bond. (C) Discuss 2 reasons for the discrepancy between the expectations and the actual change in market price for the bonds.

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