General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market today of 97.5 dollars. The zero-coupon bond pays 100 dollars in exactly one year from now. To be precise, General Motors promises to pay 100 dollars in one year's time. Of course, there is the possibility that General Motors may default on its promised payment. In the event of default, liquidators would be appointed to seil off General Motors's assets and then distribute the proceeds to bond-holders so they get some of their money back. Analysts estimate (and we accept their estimate as fact) that General Motors's assets will generate a payment of S60, per every $100 promised, in one year's time in the event of General Motors defaulting. General Motors's bonds trade freely in the market and you can sell them short if you have to (without any extra costs). You can also borrow or lend risk-free at 2% per annum (continuously compounded). There are no transactions costs. You are vworking as a trader at Morgan Stanley (a prestigious Wall Street Investment Bank). You get a phone call from a customer who has significant exposure to the risk of General Motors defaulting and she is really worried about this. She needs a hedge and she doesn't mean the gardening typel She asks if, today, you will sell her a security to help her hedge her default risk. She wants to buy a security (let us call it a DIGITAL DEFAULT contract) from you today which pays nothing at all if General Motors does NOT default but will pay her 100 dollars exactly one year from now if General Motors does default (in essence, she wants to buy a kind of insurance contract) in the intervening time period. The aim of this question is to establish at what price should you sell this DIGITAL DEFAULT contract to your customer. You assu me the absence of arbitrage. a) Set up a portfolio consisting of a short position in the DIGITAL DEFAULT contract and a position in the General Motors's bond which is risk-free to Morgan Stanley. I want you to be explicit about this portfolio (long? short? how many?) (4 marks) b) What is the value (correct to 5 decimal places) of this portfolio in dollars in one year's time? (1 mark) c) What is the value (correct to 5 decimal places) of this portfolio in dollars today? (1 mark) d) In the absence of arbitrage, and using your answer to part (c), at what price (in dollars and correct to 4 decimal places) would you sell the DIGITAL DEFAULT contract to your customer? (4 marks) e) By using the risk-neutral valuation principle, check your calculation in part (d). What is the risk- neutral probability of General Motors defaulting (correct to 4 decimal places)? (2 marks) General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market today of 97.5 dollars. The zero-coupon bond pays 100 dollars in exactly one year from now. To be precise, General Motors promises to pay 100 dollars in one year's time. Of course, there is the possibility that General Motors may default on its promised payment. In the event of default, liquidators would be appointed to seil off General Motors's assets and then distribute the proceeds to bond-holders so they get some of their money back. Analysts estimate (and we accept their estimate as fact) that General Motors's assets will generate a payment of S60, per every $100 promised, in one year's time in the event of General Motors defaulting. General Motors's bonds trade freely in the market and you can sell them short if you have to (without any extra costs). You can also borrow or lend risk-free at 2% per annum (continuously compounded). There are no transactions costs. You are vworking as a trader at Morgan Stanley (a prestigious Wall Street Investment Bank). You get a phone call from a customer who has significant exposure to the risk of General Motors defaulting and she is really worried about this. She needs a hedge and she doesn't mean the gardening typel She asks if, today, you will sell her a security to help her hedge her default risk. She wants to buy a security (let us call it a DIGITAL DEFAULT contract) from you today which pays nothing at all if General Motors does NOT default but will pay her 100 dollars exactly one year from now if General Motors does default (in essence, she wants to buy a kind of insurance contract) in the intervening time period. The aim of this question is to establish at what price should you sell this DIGITAL DEFAULT contract to your customer. You assu me the absence of arbitrage. a) Set up a portfolio consisting of a short position in the DIGITAL DEFAULT contract and a position in the General Motors's bond which is risk-free to Morgan Stanley. I want you to be explicit about this portfolio (long? short? how many?) (4 marks) b) What is the value (correct to 5 decimal places) of this portfolio in dollars in one year's time? (1 mark) c) What is the value (correct to 5 decimal places) of this portfolio in dollars today? (1 mark) d) In the absence of arbitrage, and using your answer to part (c), at what price (in dollars and correct to 4 decimal places) would you sell the DIGITAL DEFAULT contract to your customer? (4 marks) e) By using the risk-neutral valuation principle, check your calculation in part (d). What is the risk- neutral probability of General Motors defaulting (correct to 4 decimal places)? (2 marks)
Expert Answer:
Answer rating: 100% (QA)
a From the question we must determine the probability of default However we are not provided with so ... View the full answer
Related Book For
Auditing a business risk appraoch
ISBN: 978-0324375589
6th Edition
Authors: larry e. rittenberg, bradley j. schwieger, karla m. johnston
Posted Date:
Students also viewed these accounting questions
-
A refrigerator manufacturer, Zero King, issued a zero coupon bond with 10 years to maturity. What is the yield-to-maturity of this bond if it is sold for $352?
-
You purchased a zero coupon bond one year ago for $109.83. The market interest rate is now 9 percent. If the bond had 25 years to maturity when you originally purchased it, what was your total return...
-
You purchased a zero coupon bond one year ago for $425.32. The market interest rate is now 4.3 percent. If the bond had 20 years to maturity when you originally purchased it, what was your total...
-
What will be the sum of third proportional to 18 and 54 and fourth proportional to 12, 18 and LCM of 12 and 18? 1. 162 2. 216 3. 612 4. 256 526 5.
-
List the four categories of financial ratios and give an example of each. What is the purpose of ratio analysis?
-
The emf induced in the armature of a shunt generator is 596 V. The armature resistance is 0.100 . (a) Compute the terminal voltage when the armature current is 460 A. (b) The field resistance is 110...
-
For the goodness-of-fit test to be valid, each of the _______________ frequencies must be at least 5. In Exercises 9 and 10, fill in each blank with the appropriate word or phrase.
-
Kasik Co. budgeted the following cash receipts and cash disbursements for the first three months of next year. According to a credit agreement with the companys bank, Kasik promises to have a minimum...
-
The capital structure of Robinson Inn is current at 60% of equity (i.e., 40% of the debt). You find the debt issued by Robinson Inn has a pretax interest rate of 12%. You also find Robinson Inn...
-
Soybean oil is to be pumped from a storage tank to a processing vessel. The distance is 148 m and included in the pipeline are six right-angle bends, two gate valves and one globe valve. If the...
-
Explain the following under achieving Parallel processing: i. Multiplicity of functional units; ii. Parallelism and pipelining within the CPU; iii. Overlapped CPU and input /output operations; iv....
-
The Rules of Conduct would most likely be violated if an auditor: a. Owns a building and leases floor space to an attestation client. b. Has an insured account with a brokerage firm audit client. c....
-
According to the professions Rules of Conduct, an auditor would be considered independent in which of the following instances? a. The auditors checking account is held at a client financial...
-
A practitioner can perform accounting and auditing services for a privately owned client assuming that: a. The practitioner takes responsibility for managements assertions. b. The practitioner has a...
-
Which of the following published in a promotional brochure would likely violate the AICPA Rules of Conduct? a. Names and addresses, telephone numbers, numbers of partners, office hours, foreign...
-
Professional codes of ethics: a. Are uncommon in professions other than public accounting. b. Mandate ideal standards of behavior. c. Are enforceable if based in standards of ideal behavior. d....
-
Problem Management, Change Management, and Incident Management are all key processes of which framework? 1 point ITIL PCI - DSS NIST 8 0 0 - 5 3 GDPR
-
Match the following. Answers may be used more than once: Measurement Method A. Amortized cost B. Equity method C. Acquisition method and consolidation D. Fair value method Reporting Method 1. Less...
-
In what ways is the auditing profession uniquely qualified to expand into the broader arena of assurance services?
-
You are auditing FloorMart, a retailer with 200 stores around the country. It has two basic sizes of storesminimarts with 3,000 square feet and maxim arts with 7,500 square feet. Both types of stores...
-
The Sarbanes-Oxley Act dramatically changes the responsibilities of top management. Required a. Briefly indicate how Sarbanes-Oxley changes the responsibilities of top management. b. How has the...
-
Stroboscope a. produces light pulses intermittently b. has high output and is insensitive to temperature c. frequently used in velocity pickups d. has high sensitivity and frequency range e....
-
The water tank shown in Fig. 14.33 is supported by a hollow circular steel column. The tank, made of steel, is in the form of a thin-walled pressure vessel and has a capacity of 40,000 litres. Design...
-
Using the third-order Runge-Kutta method, solve Problem 11.15. Data From Problem 11.15:- Using the second-order Runge-Kutta method, solve the differential equation \(\ddot{x}+1000 x=0\) with the...
Study smarter with the SolutionInn App