A risky bond promises to pay $1,000 at the end of the year. The bond has a risk neutral probability of default of 15%. If in default, the bondʹs residual payout will be $500. If the risk free rate is 6%, what is likely price of the bond today?
A) $871
B) $925
C) $943
D) $1,000

Question

Quizplus · Accepted Answer

The correct answer is A because the expected value of the bond is $871. The probability of default is 15%, so the probability of not defaulting is 85%. The expected value of the bond is therefore:(0.85 * $1,000) + (0.15 * $500) = $871

A Risky Bond Promises to Pay $1,000 at the End