A zero-coupon bond has a beta of 0.1 and promises to pay $1,000 next year with a probability of 98%. If the bond defaults, it will pay nothing. One-year Treasury securities are yielding 5%, and the equity premium is 7%.
-Refer to the information above. What is the default premium on this bond?
A)5.7%
B)7.9%
C)0.7%
D)2.2%

Question

Quizplus · Accepted Answer

The expected return on the bond is calculated as (0.98 * $1,000) = $980. The risk-free rate is 5%, so the expected return without default risk should be $1,000 / 1.05 = $952.38. The default premium is the difference between the expected return and the risk-free return, which is $980 - $952.38 = $27.62. As a percentage of the bond's face value, this is $27.62 / $1,000 = 2.762%, which rounds to 2.2%.

A Zero-Coupon Bond Has a Beta of 0