RiskYTM_Q - + 100 (1 + x ) 2 + 100 (1 + x ) 3 + 100 (1 + x...

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Solutions HW3 New York University October 6, 2011 Chapter 6 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. 11. The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds. 1 Probability of Risk and YTM 2 A. No Default Risk 950 = 100 1 + x
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Unformatted text preview: + 100 (1 + x ) 2 + 100 (1 + x ) 3 + 100 (1 + x ) 4 + 100 (1 + x ) 5 + 1000 (1 + x ) 5 Solution is: x = 0 . 11365 3 B. Default Risk Two potential eects of default risk of 70% on face value. It could either get reected in the price or the YTM. 3.1 (a) Eect on Price p = 100 1 . 11365 + 100 (1 . 11365) 2 + 100 (1 . 11365) 3 + 100 (1 . 11365) 4 + 70 (1 . 11365) 5 + 700 (1 . 11365) 5 Solution is: p = 757 . 36 3.2 (b) Eect on YTM 950 = 100 1 + x + 100 (1 + x ) 2 + 100 (1 + x ) 3 + 100 (1 + x ) 4 + 70 (1 + x ) 5 + 700 (1 + x ) 5 Solution: x = 0 . 052152 Basically, if a price is pricing in a default risk, the implicit rate of return must be larger. 4 B. Ecient Market Hypothesis The Ecient market hypothesis must be such that rates are expected to decline and then go up again....
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RiskYTM_Q - + 100 (1 + x ) 2 + 100 (1 + x ) 3 + 100 (1 + x...

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