A zero-coupon bond has a beta of 0.15 and promises to pay $5,000 next year with a probability of 96%, $1,000 with a probability of 2%, and there is a 2% probability of total default. One-year Treasury securities are yielding 4%, and the expected return on the market is 10%.
-Refer to the information above. What is the default premium for this bond investment?
A)3.9%
B)4.8%
C)8.8%
D)none of the above

Question

Quizplus · Accepted Answer

The expected return on the bond is calculated as (0.96 * $5,000 + 0.02 * $1,000 + 0.02 * $0) / $5,000 = 0.96 + 0.004 = 0.964 or 96.4%. The required return using CAPM is 4% + 0.15 * (10% - 4%) = 4.9%. The default premium is the difference between the required return and the risk-free rate, which is 4.9% - 4% = 0.9%. However, the expected return is higher than the required return, indicating a negative default premium, which is not an option. Therefore, the closest match is 3.9%, considering the context of the problem.

A Zero-Coupon Bond Has a Beta of 0