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4. Credit spread . A band's creditspreod Is the difference between the band’s vield-to-mlturltv
Ind the vield-wmaturltv of I nomplrebie US 'l'reisurv hand (some muuritv, slme coupon nae).
2 yours to mlrurilv
Flee (Par) Value = $1,000
10% Innunl coupon rah semi-en null coupon prime ms P“ market price of us Treasury bond: P=1,074.32 => v - 3.00% per semester market price of Corporate bond: P=1,0!O.77 => y -£.15%per semester
=> Credit Spread - 4.15% - 3.00% = 1.15% per semester Supt-sing in rim-i terms and HEY com-mien:
Great Spread = 2 e 1.15% - 2.30% per year (HEY) Decomposing the Spread We can decompose our spread into two components.
We have a component related to expected loss. We also have a component related to the risk premium
built into the discount rate. Higher spreads do not necessarily mean higher expected
returns. In our example, the total spread was 2.30% The risk premium is: 7.0% - 6.0% = 1.00% The expected loss component is: 2.30% - 1.00% = 1.30%
Spread :9 Expected loss 6- Risk Premium Risk Premium and Expected Return The total risk premium is the market price of risk times the
systematic risk of the band. We started out with the CAPM to figure out what the risk
premium should be. According to theCAPM, we just need to use the correct
market portfolio to estimate beta. We oouid use a combination of equity market returns and
debt market returns => E(R“)=w.£(R‘“) +w.E(R°“-"”)+w.E(RC“"'”‘)
E(&)=r,+ﬁ.[E(R“)-r;] yesmo.M.-n....>. ...
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- Fall '10