In mid-2009, Rite Aid had CCC-rated, 7-year bonds outstanding with a yield to ma

Question

In mid-2009, Rite Aid had CCC-rated, 7-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 4%.

Suppose the market risk premium is 5% and you believe Rite Aid's bonds have a beta of 0.34.

The expected loss rate of these bonds in the event of default is 55%.

a. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009?

b. In mid-2015, Rite-Aid's bonds had a yield of

6.8%,

while similar maturity Treasuries had a yield of

1.6%.

What probability of default would you estimate now?

Explanation / Answer

A)

Rd=4%+0.34(5%) = 5.70% =y - pL=17.3% -p(0.55)

p=(17.3%-5.70%)/0.55= 21.09%

B) p=(6.8% - 1.6% -0.34(5%)/0.55=6.36 %

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