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- July 11, 2011 at 10:41 pm #349122AnonymousInactive
1.You are an investment banker and have been asked to evaluate a two-year zero coupon bond (face value = $ 1000) issued by NIKE. After assessing the likelihood of default, you believe the following are accurate assessments:
Probability of no default = 0.85
If default occurs, there is a 0.60 probability of renegotiating the debt with a $ 740 payoff and a 0.40 probability of entering bankruptcy and obtaining a $ 500 payoff.
a.What is the expected Cash flow of this instrument at maturity? (6 points)
b.If market interest rate on similar bond is 6%, what is your recommended purchase price? (4 points)
c.Assuming that your client buys the debt at your recommended price, what are the possible realized rates of return that your client could experience two years from now? (15 points) (Hint: three realized rates of return)
Hint: Part a) is a question dealing with a two-layer weighted average.
First, we need use weighted average method to calculate the expected payoff (or expected cash flow) when there is a default. Then, we need use the weighted average, again, to calculate the expected payoff (or expected cash flow) at maturity.
Hint: Part b) is a question of bond pricing. Similar as any financial security’s pricing model, we’ll discount the future expected cash flow at an appropriate discount rate. Unlike usual bond pricing question, we have more details of the future expected cash flow at the date of maturity (the answer in part a). In this situation, we need make some adjustments for the bond pricing formula, because we do not expect to get the face value at the date of maturity.
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