A bond has an expected yield-to-maturity of 10% and a 5% probability of default. If the bond defaults, the bondholder should receive 90% of the market value. If fairly priced, the bond should have a promised yield-to-maturity of
A) 11.1%.
B) 10%.
C) 9.4%.
D) 10.3%.

Question

Quizplus · Accepted Answer

The promised yield-to-maturity can be calculated considering the expected yield, the probability of default, and the recovery rate. The expected yield is a weighted average of the outcomes, where the bond does not default (95% chance of getting the promised yield) and the bond defaults (5% chance of getting 90% of the promised yield). Let Y be the promised yield, then the equation is: 0.95Y + 0.05(0.9Y) = 10%. Solving for Y gives approximately 11.1%.

A Bond Has an Expected Yield-To-Maturity of 10% and a 5