4 Commodity linked bonds are bonds which differ from straight bonds by the fact

# 4 commodity linked bonds are bonds which differ from

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4. Commodity-linked bonds are bonds which differ from straight bonds by the fact that the interest and/or principal of the bond is linked to a specified commodity price or commodity price index. Such bonds can serve as a hedge if the issuing firm produces the commodity, since payments to the bondholders rise if the price of the commodity increases, whereas they fall if the price falls. Teksako has issued a two-period bond with face value \$1000. The interest payments at t = 1 and t = 2 are linked to the price of oil by the following relationship: interest payment at t = n is price of oil at t = n price of oil at t = 0 × \$100 Thus, the interest payment increases and decreases with the oil price. (a) The t=0 price of oil is \$17 per barrel. Oil returns have a volatility of 11.78% per period. The risk-free rate is 4% per period. Construct a two-period binomial tree to determine the coupons that will be paid on the bond as the oil price changes. (b) Determine the t = 0 market value of the Teksako bond. (Note that there is no risk of default and that the first coupon is paid at t = 1.) (c) If the firm can call the Teksako bond at a price of \$1060 at t = 1 (i.e. if the bond is called, bondholders have to surrender the bond to the firm,

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