Question
) Suppose that you are able to perfectly estimate that the true default probability for Hou's Luxury Cars and Birru's Bicycles are both 5% for
) Suppose that you are able to perfectly estimate that the true default probability for Hou's Luxury Cars and Birru's Bicycles are both 5% for a 5-year horizon. You also perfectly estimate that the recovery rate of both companies (if a default occurs) will be exactly 40%. However, the yield spread on a 5-year zero coupon Hou bond is 1.5% while the yield spread on a 5-year zero coupon Birru bond is 1.4%. The two bonds have identical terms with only the issuer being different. Does this mean that at least one of the two bonds is mispriced? Why or why not?
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