3. Valuation of Risky Assets (20 points). 1. Consider the following term structures: Year 1 Year 2 Year 3 1% 1.5% 2% Term structure Time Zero-coupon yield curve for Treasures Credit spread of bond A Credit spread of bond B Credit spread of bond C 0.5% 0.75% 1% 5% 5.5% 5% 15% 10% 7.5% a) (7 points) Suppose that bonds A, B, and C have a maturity of 3 years and a coupon rate of 4% paid annually. Find the prices of these bonds. b) (5 points) Suppose that A, B, and Care bond credit ratings. Suppose also that bonds A, B, and C are the only defaultable bonds traded in the market. You are an inexperienced buyer, and you do not observe individual bond ratings. So, all bonds appear identical to you. However, you know that the number of bonds with each rating traded in the market is the same (e.g., 10,000 bonds A, 10,000 bonds B, and 10,000 bonds C). What is the highest price you will be willing to offer for a random bond offered to you by your dealer (3 points)? State clearly all your assumptions (2 points). c) (8 points) At what price will you buy a defaultable bond, assuming that both you and the dealer are rational, and everyone is fully aware of your informational disadvantage vis-a-vis the dealer? 3. Valuation of Risky Assets (20 points). 1. Consider the following term structures: Year 1 Year 2 Year 3 1% 1.5% 2% Term structure Time Zero-coupon yield curve for Treasures Credit spread of bond A Credit spread of bond B Credit spread of bond C 0.5% 0.75% 1% 5% 5.5% 5% 15% 10% 7.5% a) (7 points) Suppose that bonds A, B, and C have a maturity of 3 years and a coupon rate of 4% paid annually. Find the prices of these bonds. b) (5 points) Suppose that A, B, and Care bond credit ratings. Suppose also that bonds A, B, and C are the only defaultable bonds traded in the market. You are an inexperienced buyer, and you do not observe individual bond ratings. So, all bonds appear identical to you. However, you know that the number of bonds with each rating traded in the market is the same (e.g., 10,000 bonds A, 10,000 bonds B, and 10,000 bonds C). What is the highest price you will be willing to offer for a random bond offered to you by your dealer (3 points)? State clearly all your assumptions (2 points). c) (8 points) At what price will you buy a defaultable bond, assuming that both you and the dealer are rational, and everyone is fully aware of your informational disadvantage vis-a-vis the dealer