Question

1. Suppose you bought a $1000, 10-year, 5% coupon bond for $900, but soon! found out that default was likely. What probability of default would just make the yield on this bond equal to zero?. a. 0.2 b. 0.3 c. 0.4 d. 0.5

Answer 1

Calculation of IRR:

Bond Price	-900
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Coupon	50
Face value+Coupon	1050
IRR	6.3835%

Now probability of default whall reduce the regular coupon amount receivable and face value receivable at the end.

In the Probability of default column we shall put values one by one. We shall find that at .4 default probability the irr becomes zero.

Clipboard Font Alignment fx =B2*(1-$E$5) B -900 c -900 30! 30 30 Probability of Default 0.4 A 1 Bond Price 2 Coupon 3 Coupon 4 Coupon 5 Coupon 6 Coupon 7 Coupon 8 Coupon 9 Coupon 10 Coupon 11 Face value+Coupon 12 IRR 30 30 50 30 30 1050 6.3835% 630 0.0000%

Hence andwer is c. 0.4

Note: IRR has been calculated using =irr(c1:c11).