The Dunley Corp. plans to issue 5-year bonds. It believes the bonds will have a BBB rating. Suppose AAA bonds with the same maturity have a

5%

yield. If the market risk premium is

5%

using the data in the tables

a. Estimate the yield Dunley will have to pay, assuming an expected 60% loss rate in the event of default during average economic times. What spread over AAA bonds will it have to pay?

b. Estimate the yield Dunley would have to pay if it were a recession, assuming the expected loss rate is 90% at that time but the beta of debt and market risk premium are the same as in average economic times. What is Dunley's spread over AAA now?

c. In fact, one might expect risk premia and betas to increase in recessions. Redo part (b) assuming that the market risk premium and the beta of debt both increase by 20%, that is they equal 1.20 times their value in recessions.

(Click on the following icon in order to copy its contents into a spreadsheet.) Annual Default Rates by Debt Rating (1983-2011) Rating: AAA AA A BBB BB B CCC CC-C Default rate: Average 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2% 14.1% In recessions 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0% 79.0% Source: "Corporate Defaults and Recovery Rates, 19202011," Moody's Global Credit Policy, February 2012. (Click on the following icon in order to copy its contents into a spreadsheet.) Average Debt Betas by Rating and Maturity A and above BBB BB 15 Yr Average beta 0.01 0.06 0.07 0.14 Source: S. Schaefer and I. Strebulaev, "Risk in Capital Structure Arbitrage," Stanford GSB working paper, 2009