Genevieve Marseille, a credit analyst for Calliope Partners, is considering two different bond issues from Beignet Bakeries. The quant group at Calliope Partners provided Marseille with government benchmark spot rates and a no-arbitrage binomial interest rate tree assuming 20% volatility, along with the par rates from which they were derived: Beignet Bakeries is currently doing well, but has major pension contributions due over the next few years and Marseille believes the pension obligations will increase Beignet's default risk. Consequently, Marseille estimates Beignet's annual conditional default probability (hazard rate) to be: These hazard rates apply to all Beignet Bakeries' bonds due to cross-default provisions. a. The first Beignet bond Marseille is considering is a senior secured bond with a 5% annual coupon and four years until maturity. Because this bond is secured by quality collateral, the expected recovery rate is constant at 80% across all four years. What is the fair value senior secured bond? ( 3 points) b. The second Beignet bond Marseille is considering is a subordinated floating rate note (FRN) with an annual coupon rate equal to the benchmark return plus 2% and four years until maturity. Marseille expects the recovery rate on the FRN to decline over time: What is the fair value of the subordinated FRN? (3 points) c. If the market price of Beignet's senior secured bond is 100.5 per 100 of par and the market price of the subordinated FRN is 95.50 per 100 of par, which bond should Marseille purchase? Why?(1 point) Genevieve Marseille, a credit analyst for Calliope Partners, is considering two different bond issues from Beignet Bakeries. The quant group at Calliope Partners provided Marseille with government benchmark spot rates and a no-arbitrage binomial interest rate tree assuming 20% volatility, along with the par rates from which they were derived: Beignet Bakeries is currently doing well, but has major pension contributions due over the next few years and Marseille believes the pension obligations will increase Beignet's default risk. Consequently, Marseille estimates Beignet's annual conditional default probability (hazard rate) to be: These hazard rates apply to all Beignet Bakeries' bonds due to cross-default provisions. a. The first Beignet bond Marseille is considering is a senior secured bond with a 5% annual coupon and four years until maturity. Because this bond is secured by quality collateral, the expected recovery rate is constant at 80% across all four years. What is the fair value senior secured bond? ( 3 points) b. The second Beignet bond Marseille is considering is a subordinated floating rate note (FRN) with an annual coupon rate equal to the benchmark return plus 2% and four years until maturity. Marseille expects the recovery rate on the FRN to decline over time: What is the fair value of the subordinated FRN? (3 points) c. If the market price of Beignet's senior secured bond is 100.5 per 100 of par and the market price of the subordinated FRN is 95.50 per 100 of par, which bond should Marseille purchase? Why?(1 point)
