Consider the following yields on riskless securities 1: 16% for the first year, 1.26% for the second year and 1.35% for the third year. These are forward rates. What is the present value or implied price of a three-year par $1,000 zero coupon bond assuming annual compounding? What is the value assuming continuous compounding? Annual compounding $ _____ Continuous compounding $ _____ Now consider the bond front question 4 but using a binomial tree to incorporate default risk. Each year there is a 10% chance that the issuer defaults and the bond owner receives nothing. There is 90% chance that the issuer survives. Draw a binomial tree for this situation and use it to value the bond with annual compounding. Bond value $ _____ Now consider the bond from question 5 but assuming 60% recovery. This means that if the bond defaults, the bondholder receives 60% of par or in this example $600 (remember to discount). Bond value $ _____ What is the yield on the risky bond question 6? In other words, at what rate would you have to discount the payment of $1000 at the end of year 3 to equal the bond value you computed? Risky bond yield _____ % Consider the binomial tree of interest rates developed in class: the first year the rate is 6% and it moves up or down 2% each year with equal probability. A three-year zero coupon par $100 bond has a value of $84.08 today. What is the expected value of the bond if interest rates are more likely to go up (60% probability) than to go down (40% probability)