Assume that a one-year Treasury strip is currently yielding 5.5 percent and an AAA-rated discount bond with

Question:

Assume that a one-year Treasury strip is currently yielding 5.5 percent and an AAA-rated discount bond with similar maturity is yielding 8.5 percent.

a. If the expected recovery from collateral in the event of default is 50 percent of principal and interest, what is the probability of repayment of the AAA- rated bond? What is the probability of default?

b. What is the probability of repayment of the AAA-rated bond if the expected recovery from collateral in the case of default is 94.47 percent of principal and interest? What is the probability of default?

c. What is the relationship between the probability of default and the propor- tion of principal and interest that may be recovered in case of default on the loan?

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