D Question 4 10 pts Consider a $1,000-par junk bond paying a 12% annual coupon.
ID: 1171606 • Letter: D
Question
D Question 4 10 pts Consider a $1,000-par junk bond paying a 12% annual coupon. The issuing company has 20% chance of defaulting this year; in which case, the bond would not pay anything. If the company survives the first year, paying the annual coupon payment, it then has a 25% chance of defaulting in the second year. If the company defaults in the second year, neither the final coupon payment nor par value of the bond will be paid. Assume that periodic cash flows are reinvested at 10%. What price must investors pay for this bond to expect a 10% yield to maturity to the nearest penny? $ At that price, what is the expected holding period return? Standard deviation of returns to 1 decimal place? 1% Question 5 10 pts FS 5 0Explanation / Answer
Solution:- a) Price of the bond = $781.49 b) Holding peroid return = -0.5% c) Standard deviation =74.5% Workings:- a) Calculation of expected cash flows (ECF) At year 1 = 0.20*(0)+0.80*(120)=$96 At year 2 =0.25*(0)+0.75*(1,120)=$840 Hence the price of the bond today shouldbe =ECF1/(1.1)+ECF2/(1.1)^2 =96/1.1+840/(1.1)^2 =$781.49 Calculation of Holding peroid return and standard deviation Joint probability Final cash flow Holding peroid return Prob*HPR HPR-EXpHPR Prob*(HPR-EXpHPR)^2 In "%" In "%" "%" (%)^2 0.2 0 -100.00 -20.00 -99.50 1980.05 0.2 132 -83.11 -16.62 -82.61 1364.88 0.6 1252 60.21 36.12 60.71 2211.42 Total -0.50 5556.35 The joint probability = 0.80(year1)*0.25(year2)=0.20 Final cash flow = 120*1.1= 132 Other joint probability = 0.80*0.75= 0.60 Final cash for this = 120*1.1+1120=1252 b) Hence the expected holding peroid return = -0.50% c) The standard deviation = (Prob*(HPR-EXpHPR)^2)^(1/2) =(5556.35)^(1/2) =74.54% Please feel free to ask if you have any query in the comment section.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.