econ423hw2essayanswer - 2 0.25 (0) 0.75 (1,120) 840 The...

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Solution for Mishkin and Eakins, p. 96, Quantitative Problem #2: 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. What price must investors pay for this bond to expect a 10% yield to maturity? At that price, what is the expected holding period return? Standard deviation of returns? Assume that periodic cash flows are reinvested at 10%. Solution: The expected cash flow at t 1 0.20 (0) 0.80 (120) 96 The expected cash flow at t
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Unformatted text preview: 2 0.25 (0) 0.75 (1,120) 840 The price today should be: 2 96 840 781.49 1.10 1.10 P At the end of two years, the following cash flows and probabilities exist: Probability Final Cash Flow Holding Period Return Prob HPR Prob (HPR Exp. HPR) 2 0.2 $ 0.00 100.00% 20.00% 19.80% 0.2 $ 132.00 83.11% 16.62% 13.65% 0.6 $1,252.00 60.21% 36.12% 22.11% 0.50% 55.56% The expected holding period return is almost zero ( 0.5%). The standard deviation is roughly 74.5% [the square root of 55.56%]. Note that this solution key is somewhat brief - if you would like a more elaborate explanation as to how to solve this problem, feel free to email me or come to office hours and I will be happy to explain in more detail if you are confused. Thanks, Lauren...
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This note was uploaded on 08/31/2009 for the course ECON 423 taught by Professor Vd during the Summer '08 term at UNC.

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