Calculating Default – Adjusted Expected Bond Returns, business & finance homework help

1. A newly issued bond with 1 year maturity has a price of 100, which equals its face value. The coupon rate on the bond is 15%; the probability of default in 1 year is 35%; and the bond’s payoff in default will be 65% of its face value.

a. Calculate the bonds’s expected return

b. Create a data table showing the expected return as a function of the recovery percentage and the price of the bond.

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2. Consider the case of five possible rating states A, B, C, D, and E. A, B, and C are initial bond ratings, D symbolizes first time default in the previous period. Assume that the transition matrix Y is:

1 0 0 0 0

0.06 0.90 0.03 0.01 0

Y= 0.02 0.05 0.88 0.05 0

0 0 0 0 1

0 0 0 0 1

A 10 year bond issued today at par with an A rating is assumed to bear a coupon rate of 7%.

– If a bond is issued today at par with a B rating and with a recovery percentage of 50%, what should be its coupon rate so that its expected return will also be 7%?

– If a bond is issued today at par with a C rating and with a recovery percentage of 50%, what should be its coupon rate so that its expected return will be 7%?

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