where did 0.98 and 0.99 come from? EXAMPLE 5-14 Bond Investment A financial advi
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where did 0.98 and 0.99 come from?
EXAMPLE 5-14 Bond Investment A financial adviser suggests that his client select one of two types of bonds in which to invest $5000, Bond X pays a return of 4% and has a default rate of 2%. Bond Y has a 23% return and a defaultrate of 1%. Find the expected rate of return and decide which bond would be a better investment. When the bond defaults, the investor loses all the investment. SOLUTION The return on bond X is $5000-4% = $200. The expected return then is E(X) = $200(0.98)-$5000(0.02)-S96 The return on bond Y is $5000-21%-$125. The expected return then is E(X) $125(0.99) _ $5000(0.01)-$73.7s Hence, bond X would be a better investment since the expected return is highorExplanation / Answer
0.98 is the probability of no default on bond X as the probability of default on bond X is 0.02 (2%) and if the bond defaults client will get nothing (no coupon and no repayment) and to calculate expectation we have to consider both scenarios i.e. of default and of no default.
similarly, 0.99 is the probabilityof no default on bond Y
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