4 Bond Values, Yields and Interest Rates Suppose a 1 dollar bond with 1 year maturity has a 1 dollar face value and is trading at a 33 percent discount. What is the market value of the bond? The contractual interest rate is 8 percent. What is the effective nominal yield on the bond? Now suppose a bond with 1 year maturity has a face value of d dollars (including prin- cipal and interest). There is a probability of 33 percent that the bond issuer (borrower) will default completely. Otherwise, the issuer will pay in full. What the market value v of the bond? The contractual interest rate is 8 percent. What is the effective nominal yield on the bond? Suppose the default probability increases to 50 percent. What is the market value v' of the bond now? At a contractual interest rate of 8 percent, what is the effective nominal yield on the bond now? Consider an investor. There are two bonds. One pays v' with 100 percent certainty. The other bond pays d with a 50 percent chance, and zero otherwise. Which bond, if any, will the investor prefer? 4 Bond Values, Yields and Interest Rates Suppose a 1 dollar bond with 1 year maturity has a 1 dollar face value and is trading at a 33 percent discount. What is the market value of the bond? The contractual interest rate is 8 percent. What is the effective nominal yield on the bond? Now suppose a bond with 1 year maturity has a face value of d dollars (including prin- cipal and interest). There is a probability of 33 percent that the bond issuer (borrower) will default completely. Otherwise, the issuer will pay in full. What the market value v of the bond? The contractual interest rate is 8 percent. What is the effective nominal yield on the bond? Suppose the default probability increases to 50 percent. What is the market value v' of the bond now? At a contractual interest rate of 8 percent, what is the effective nominal yield on the bond now? Consider an investor. There are two bonds. One pays v' with 100 percent certainty. The other bond pays d with a 50 percent chance, and zero otherwise. Which bond, if any, will the investor prefer