2 points

QUESTION 5

1. You are going to make an investment of $1000, and are considering 2 options: Option one is a zero-coupon 5-year bond of a company that just declared bankruptcy. Its face value is $1000 and its current price is $250 (so you would purchase 4 of them). You believe that at the time of bond maturity, there is a 50% chance that bond holders will end up receiving 20% of face value, and a 50% chance that bond-holders will receive 35% of face value (there is no chance the bond-holders will receive the full $1000 of face value)

   Option two is a 5-year zero-coupon treasury note of the US government. It is default-risk free, and will give an effective annual return of 7%.

   What is the expected return of the risky corporate bond over the 5-year holding-period (in %)?

   %

   What is its effective annual return? (in % rounded to two decimal places)

   %

   Which one of these statements is true?

   A) The risky corporate bond is the superior investment B) The government bond is the superior investment C) Which investment is best depends on whether an investor is risk averse or not.

   in the blank please write one of the following: A B C