Consider the following information regarding corporate bonds:RatingAAAAAABBBBBBCCCAverage Default Rate0.0%0.0%0.2%0.4%2.1%5.2%9.9%Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%43.0%Average Beta0.050.050.050.100.17 0.26 0.31Perpetual Motors plans to issue 10-year bonds that it believes will have a BBB rating. Suppose AAA bonds with the same maturity have a 2% yield. Assume that the market risk premium is 5% and the expected loss rate in the event of default on the bonds is 65%. The yield that these bonds will have to pay during average economic times is closest to:A.4.50%B.3.50%C.4.00%D.2.50%
Question
Consider the following information regarding corporate bonds:RatingAAAAAABBBBBBCCCAverage Default Rate0.0%0.0%0.2%0.4%2.1%5.2%9.9%Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%43.0%Average Beta0.050.050.050.100.17 0.26 0.31Perpetual Motors plans to issue 10-year bonds that it believes will have a BBB rating. Suppose AAA bonds with the same maturity have a 2% yield. Assume that the market risk premium is 5% and the expected loss rate in the event of default on the bonds is 65%. The yield that these bonds will have to pay during average economic times is closest to:A.4.50%B.3.50%C.4.00%D.2.50%
Solution
The yield on a corporate bond is typically composed of the risk-free rate (in this case, the yield on AAA bonds), a premium for default risk, and a premium for systematic risk.
The default risk premium can be estimated as the product of the average default rate and the loss given default. For BBB-rated bonds, the average default rate is 0.4% and the loss given default is 65%, so the default risk premium is 0.4% * 65% = 0.26%.
The systematic risk premium can be estimated using the Capital Asset Pricing Model (CAPM), which is the product of the bond's beta and the market risk premium. For BBB-rated bonds, the beta is 0.10 and the market risk premium is 5%, so the systematic risk premium is 0.10 * 5% = 0.50%.
Adding these components together gives the yield on the BBB-rated bonds:
Yield = Risk-free rate + Default risk premium + Systematic risk premium = 2% + 0.26% + 0.50% = 2.76%
Therefore, the yield that these bonds will have to pay during average economic times is closest to 2.76%. However, none of the options match this value. There might be a mistake in the question or the options provided. The closest option to the calculated value is D. 2.50%.
Similar Questions
Consider the following information regarding corporate bonds and answer the following questions:RatingAAAAAABBBBBBCCCAverage Default Rate0.0%0.1%0.2%0.5%2.2%5.5%12.2%Recession Default Rate0.0%1.0%3.0%3.0%8.0%16.0%48.0%Average Beta0.050.050.050.100.170.260.31Smartline Corp plans to issue 10-year bonds that it believes will have a B rating. Suppose AAA bonds with the same maturity have a 5% yield. Assume that the market risk premium is 6% and the expected loss rate in the event of default on the bonds is 65%. What is the yield that these bonds will have to pay during recession times? (3 marks)Your firm is considering expanding its consumer division. You identify Negtle as a comparable firm. Suppose Negtle has a market capitalization of 120 billion and a beta of 1.27. Negtle also has $30 billion of BBB-rated debt outstanding, with an average yield of 4.3%. Estimate the cost of capital of your firm’s investment given the risk-free rate of 4% and a market risk-premium of 6% (3 marks).
Consider the following information regarding corporate bonds:Rating AAA AA A BBB BB B CCCAverage Default Rate 0.0% 0.1% 0.2% 0.45% 2.2% 5.5% 12.2%Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31CompanyMarketCapitalization($mm)TotalEnterpriseValue ($mm)EquityBetaDebtRatingTaggart Transcontinental $4500 8000 1.1 BBBRearden Metal $3800 7200 1.3 AAAWyatt Oil $2400 3800 0.9 ANielson Motors $1500 4400 1.75 BB1. Your estimate of the debt beta for Taggart Transcontinental would be:A) 0.05B) 0.10C) 0.17D) 1.00
1FINA2222Practice Questions for Final ExamSemester 2 2023Chapter 12Use the following information to answer the question(s) below.Consider the following information regarding corporate bonds:Rating AAA AA A BBB BB B CCCAverage Default Rate 0.0% 0.1% 0.2% 0.45% 2.2% 5.5% 12.2%Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31CompanyMarketCapitalization($mm)TotalEnterpriseValue ($mm)EquityBetaDebtRatingTaggart Transcontinental $4500 8000 1.1 BBBRearden Metal $3800 7200 1.3 AAAWyatt Oil $2400 3800 0.9 ANielson Motors $1500 4400 1.75 BB1. Your estimate of the debt beta for Taggart Transcontinental would be:A) 0.05B) 0.10C) 0.17D) 1.00
Use the following information to answer the question(s) below.SecurityTerm(years)Yield(%)Treasury 20 5.5%AAA Corporate207.0%BBB Corporate208.0%B Corporate209.6%The credit spread on AAA-rated corporate bonds is:a.2.6%.b.4.1%.c.1.5%.d.7%.e.1.0%.
Consider the following yields to maturity on various one-year zero-coupon securities: SecurityYield (%)Treasury4.6AAA corporate4.8BBB corporate5.6B Corporate6.2The price (expressed as a percentage of the face value) of a one-year, zero-coupon corporate bond with a BBB rating is closest to:a.92.70b.95.60.c.94.16.d.94.70.e.95.42.
Upgrade your grade with Knowee
Get personalized homework help. Review tough concepts in more detail, or go deeper into your topic by exploring other relevant questions.