You buy a bond for $1,000 today that promises interest of $50 in one year plus the return of your principal. However, the probability that the company will default and not pay you either interest nor repay your principal is 1 percent.The expected return on the bond is _____percent.

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Quizplus · Accepted Answer

The expected return is calculated by considering both the scenario where the company pays back the interest and principal and the scenario where it defaults. If the company does not default, the return is $50 on a $1000 investment, which is 5%. The probability of this happening is 99% (100% - 1% default probability). If the company defaults, the return is -$1000 (loss of the entire principal), with a 1% probability. The expected return (ER) is calculated as: ER = (0.99 * 5%) + (0.01 * -100%) = 4.95% - 1% = 3.95%.

You Buy a Bond for $1,000 Today That Promises Interest