A)

Suppose a 9-year corporate bond with a coupon of 5.4% per year payable annually

has a yield of 4.7% (continuous compounding). The yields for all maturities on risk-

free bonds are 3.2% per year (continuous compounding). Assume that defaults can

take place at the middle of every year and the recovery rate is 43%. Estimate the

default probability assuming that the unconditional default probabilities are the same

on each possible default date. What is approximate default probability?

B)

Repeat question B) by assuming that the 43% recovery rate is applied to the market

value of the risk-free bond as opposed to par. Compare the default probability with

that in A) and explain the difference. Note: in practice, the recovery rate is applied to

the par. Only in this question, we make the special assumption in order to derive

some insights.