Question
Assume it is 11.16.2020. Bankruptcies are looming on the horizon since the economic fallout from CoVid has created risk for almost every firm. A corporate
Assume it is 11.16.2020. Bankruptcies are looming on the horizon since the economic fallout from CoVid has created risk for almost every firm. A corporate bond matures about one year (11/16/2021). Please ignore net present values and concentrate on values to be paid in the future. In other words, even though a dollar to be received in a year is worth less than a dollar today, for the time being, let us just talk about the values at the time of maturity. The bond promises a single payment of interest of $65 paid at maturity as well as its principal (face value) of $1,000. The bond has a 14% probability of default and payment under default (for everything interest and principal) is $425. The investor buys the bond today (11.16.2020) for $820.
1. What is the promised (contractual) yield to maturity on the Bond (simple annual compounding) for the investor when he/she buys the Bond on 11.16.2020 based upon the purchase price and the Bonds terms (what the Company promised to pay)?
2. What is the expected yield (simple annual compounding) to maturity for the investor when he/she buys this Bond?
3. Does it make sense to buy Credit Insurance at the same time you buy the Bond to insure (be made whole) against the risk of a credit default if the Bank (or insurance company) selling the credit-default insurance costs $160 for this Bond? Why or Why not? Is there any other piece of information that you need to make an intelligent decision?
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