Daniela Ibarra is a senior analyst in the fixed-income department of a large wealth management firm. Marten Koning is a junior analyst in the same department, and David Lok is a member of the credit research team.

The firm invests in a variety of bonds. Ibarra is presently analyzing a set of bonds with some similar characteristics, such as four years until maturity and a par value of €1,000. Exhibit 1 includes details of these bonds.

Ibarra asks Koning to assist her with analyzing the bonds. She wants him to perform the analysis with the assumptions that there is no interest rate volatility and that the government bond yield curve is flat at 3%.

Ibarra performs the analysis assuming an upward-sloping yield curve and volatile interest rates. Exhibit 2 provides the data on annual payment benchmark government bonds.

She uses these data to construct a binomial interest rate tree based on an assumption of future interest rate volatility of 20%.

Answer the first five questions (1–5) based on the assumptions made by Marten Koning, the junior analyst. Answer Questions 8–12 based on the assumptions made by Daniela Ibarra, the senior analyst.

All calculations in this problem set are carried out on spreadsheets to preserve precision. The rounded results are reported in the solutions.

David Lok has estimated the probability of default of Bond B1 to be 1.50%. He is presenting the approach the research team used to estimate the probability of default. Which of the following statements is Lok likely to make in his presentation if the team used a reduced-form credit model?

A. Option pricing methodologies were used, with the volatility of the underlying asset estimated based on historical data on the firm’s stock price.

B. Regression analysis was used, with the independent variables including both firmspecific variables, such as the debt ratio and return on assets, and macroeconomic variables, such as the rate of inflation and the unemployment rate.

C. The default barrier was first estimated, followed by the estimation of the probability of default as the portion of the probability distribution that lies below the default barrier.

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EXHIBIT 1 A Brief Description of the Bonds Being Analyzed Description A zero-coupon, four-year corporate bond with a par value of €1,000. The wealth management firm's research team has estimated that the risk-neutral probability of default for each date for the bond is 1.50%, and the recovery rate is 30%. A bond similar to B1, except that it has a fixed annual coupon rate of 6% paid annually. A bond similar to B2 but rated AA. A bond similar to B2 but the coupon rate is the one-year benchmark rate plus 4%. Bond B1 B2 B3 B4