Laurentide Resorts is issuing commercial paper with 60 days to maturity.In case of default, the investor will receive 40 cents on the dollar.The quoted rate for the issue is 7%, and an equivalent government-backed security's rate is 6%.What is the probability of default?
A)98.51%
B)0.94%
C)1.0%
D)1.49%

Question

Quizplus · Accepted Answer

We can use the following formula to calculate the probability of default:
P(D) = (R(1 - Rf))/(1 - R)
Where:
R = quoted rate = 7%
Rf = risk-free rate = 6%
P(D) = probability of default
Plugging in the values, we get:
P(D) = (0.07-0.06)/(1-0.4x(0.07-0.06))
P(D) = 0.0149 or 1.49%
Therefore, the best choice is D as it gives the correct probability of default.

Laurentide Resorts Is Issuing Commercial Paper with 60 Days to Maturity.In