Consider a one-year corporate bond that has a 20% probability of default. The payoff on the bond is $2,000 if the corporation does not default. The interest rate is 10%. If buyers of this bond are risk-neutral, this bond will sell for:

Question

Quizplus · Accepted Answer

Risk-neutral investors will calculate the expected payoff of the bond and then discount it back to its present value. The expected payoff is (0.8 * $2,000) = $1,600 because there's an 80% chance (1 - 0.2) the corporation will not default and the bond will pay $2,000. To find the present value, we discount this amount by the interest rate of 10%, which gives us $1,600 / (1 + 0.1) = $1,454.54.

Consider a One-Year Corporate Bond That Has a 20% Probability