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solution

The government issues 1.year bond. It is a bullet bond with 4% nominal interest rate. It is sold par value when issued.

Company is looking at a similar bond with 5% nominal interest rate. PD of the company the next year is 0.5%.

If the company will indeed default R = 40% and LGD = 60%

a. Lets assume default risk of the company is only specific risk, so completely diversifiable risk (beta=0)

– for what price should should the bond be sold?

– what is the yield on the bond?

– what is the default risk premium on the corporate bond then ?

b. Lets assume that the default risk of the company is not diversifiable risk and that the investors demand 1% risk premium for the bond. So the Rc of the bond is 1% hight per year than Rf.

– for what price should should the bond be sold?

– what is the yield on the bond?

– what is the default risk premium on the corporate bond then ?

– If the company wants to sell the bond par value what will the nominal interest rate of the bond be?

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