2. The market yield to maturity on a risky bond is currently listed at 14.50 per

Question

2. The market yield to maturity on a risky bond is currently listed at 14.50 percent.
The risk-free interest rate is estimated to be 9.25 percent. What is the defaultrisk
premium, all other factors removed? The promised yield on this bond is
15 percent. A certain investor looking at this bond estimates there is a
25 percent probability the bond will pay 15 percent at maturity, a 50 percent
probability it will pay a 10 percent return, and a 25 percent probability it will
yield only 5 percent. What is the bond’s expected yield? What is this investor’s
anticipated default loss? Will the investor buy this bond?

Explanation / Answer

risk premium = market rate - risk free rate = 14.5 - 9.25 = 5.25% (ANSWER) Expected return = 0.25*15+0.50*10+0.25*5 = 10% (ANSWER) Anticipated default loss = Promised yield - expected yield = 15 -10 = 5% (ANSWER) Obviously the investor will not buy this bond. (ANSWER)

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