A zero-coupon bond does not pay any interest out over the lifetime of the bond. Instead, it pays the principal out at maturity and that is the only payment made. Consider a zero-coupon bond that pays 1$ after 5 years. You may assume that inflation and interest rates will be 0 for the next 5 years.

The bond has a default rate each year of = 2.5% If the bond defaults, you get nothing.

1. 2.

(5 points) What is the most that you, the investor, would be willing to pay for the bond today?

(10 points) Now assume that if the bond defaults in the first 2 years, you get nothing. If it defaults after the first 2 years you get a recovery rate of 70%, i.e. you are paid 0.7$. If it does not default over the five years, you are paid the 1$ same as before. What is the most an investor would be willing to pay for the bond?