Is it true that a Government of Canada security is risk-free? Which has greater
ID: 2731802 • Letter: I
Question
Is it true that a Government of Canada security is risk-free? Which has greater interest rate risk, a 30-year Canada bond or a 30-year BB corporate bond? With regard to bid and ask prices on a Canada bond, is it possible for the bid price to be higher? Why or why not? Canada bid and ask quotes are sometimes given in terms of yields, so there would be a bid yield and an ask yield. Which do you think would be larger? Explain. A company is contemplating a long-term bond issue. It is debating whether or not to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?Explanation / Answer
As we know that “Call Provision” is a clause in a bond that grants “right to call” to its issuer, which means, the issuer can end the bond prior to its maturity date using its call provision. This generally creates a safeguard for the company against an unforeseen future dip in the interest rates. If interest rates fall in the economy, the firm can call its current bonds back using its “right to call” and would save on its debt cost (i.e. coupon rate).
Though a “Call Provision” benefits the issuer, it carries a certain cost as well. The cost of a “Call Provision” is generally the call premium, which firm needs to pay, if it would call the bond prior to its maturity period. Generally, a “Call Provision” comes with a pre-defined validity duration, after which the call provision ends and bond converts into a regular bond.
A ”Put Provision” is an arrangement, which provides its investor a “right to sell”, which means if an investor wants to sell its bond to the firm back prior to its maturity date, the firm is bound to purchase it back. It provides its investor an added degree of security as it establishes a floor price for the bond.
An investor is likely to use his put provision, when there is a hike in interest rates. In such a scenario, investor will end his investment in the bond and will purchase a new bond with higher coupon rates from the market.
The “Put Provision” comes with a cost, which is known as “Put Premium” and is paid by investors to the firm as the firm is taking an extra risk.
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