Question

Today is time t. Two zero coupon bonds both have a face value of 100 dollars, which means both bonds are expected to pay $100 at Maturity (time T). Bond A is liquid and is often traded by average institutional investors at zero transaction costs. Bond B is illiquid. Its total direct and indirect trading cost is $5 per trade (either buy or sell). Suppose an average-sized institutional trader who wants to own the two bonds will trade three times in either bond (i.e., first buy it at t, then sell it and buy it back again at some time between t and T). Interest rate for discounting future bond price is zero for both bonds. In other words, everyone in this market is not risk averse. What should be the average trader’s evaluation of the bond A and B price today?
A. 100,90
B. 100,100
C. 100,95
D. 100,85

Answer 1

Answer:

The correct answer is (D) 100,85

Explanation:

Solution:

Two zero coupon bonds both have a face value of = $100

Bond A is liquid and traded by average institutional investors at = 0 transaction costs

Bond B is liquid, with a trading cost of =$5

Now,

As the interest rate for discounting future price is zero, then the Bind price is represented as follows:

Bond price = face value - trading cost

Bond A price = 100 - 3*0 = 100

Bond B price = 100 - 3*5 = 85

Therefore, the average trader's evaluation of the bond A and bond B price today is = 100,85