What will be his holding period return if the firm defaults

Assignment Help Financial Management

Reference no: EM132033939

Mr. Weiss just bought a zero-coupon bond issued by Risky Corp. for $930, with $1000 face value and one year to mature. He believes that the market will be in expansion with probability 0.95 and in recession with probability 0.05. In the event of expansion, Risky Corp. can always repay the debt. In the event of recession, the company would fail to meet its debt obligation. The bondholders would recover nothing and completely lose their investment, should the firm default. A zero-coupon government bond with the same maturity and face value is selling at $970.87. Assume that the government never defaults. The expected value and the standard deviation of the return of the market portfolio are 10% and 40%, respectively. Risky Corps bond return has a correlation of 0.75 with the market portfolio return. Assume that interest is compounded annually.

(a) Suppose Mr. Weiss holds the bond to maturity. What will be his holding period return if Risky Corp. does not default? What will be his holding period return if the firm defaults?

(b) What is the expected return of the Risky Corp. bond? Is the bond risky or riskfree? Explain.

(d) Compare the expected return of the Risky Corp. bond with the riskfree rate. Would a risk-averse investor buy the Risky Corp. bond at $930? Explain.

(e) What is the standard deviation of the return of the Risky Corp. bond? What is the beta of the bond? What would be the equilibrium expected return of the Risky Corp. bond if the CAPM holds? Does Mr. Weiss overvalue or undervalue the bond relative to the CAPM?

(f) Suppose Mr. Weiss changes his mind and sells his Risky Corp. bond. He invests in a portfolio that allocates 60% of the money on the market portfolio, and the other 40% on the government bond. What are the expected value and the standard deviation of his portfolio return? Is his portfolio efficient? Explain.

Reference no: EM132033939

Questions Cloud

What should management do to recuse the cost of capital : What should management do to recuse the cost of capital? Why would that be successful?

Statements is true about the efficient market hypothesis : Which of the following statements is true about the efficient market hypothesis?

Net income to the controlling and noncontrolling interests : determine the proper allocation of consolidated net income to the controlling and noncontrolling interests?

Sensitivity of the npv to changes in the price of new clubs : McGilla Golf has decided to sell a new line of golf clubs. What is the sensitivity of the NPV to changes in the price of the new clubs?

What will be his holding period return if the firm defaults : What will be his holding period return if Risky Corp. does not default? What will be his holding period return if the firm defaults?

Find mispriced securities will make markets more efficient : The competition of trying to be the first to find mispriced securities will make markets more efficient. Do you agree with Mark? Why or why not?

Portion of your current assets with long term loan : What argument would you use to persuade a banker to finance a portion of your current assets with a long term loan?

What is the NPV for this project : The OCF of the project will be $878269. The tax rate is 30 percent, and the cost of capital is 8 percent. What is the NPV for this project?

Analyze the value of potential investment : You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows.

User Account

All Pages