The Isabelle Corporation rents prom dresses in its stores across the southern United States. It has just issued a five-year, zero-coupon corporate bond at a price of $77. You have purchased this bond and intend to hold it until maturity.

a. What is the yield to maturity of the bond?

b. What is the expected return on your investment (expressed as an EAR) if there is no chance of default?

c. What is the expected return (expressed as an EAR) if there is a 100% probability of default and you will recover 90% of the face value?

d. What is the expected return (expressed as an EAR) if the probability of default is 50%, the likelihood of default is higher in bad times than good times, and, in the case of default, you will recover 90% of the face value?

e. For parts (b–d), what can you say about the five-year, risk-free interest rate in each case?

Sovereign Bonds