A bond has an expected yield-to-maturity of 12% and a 5% probability of default. If the bond defaults, the bondholder should receive 75% of the market value. The bond would be fairly priced if its default premium were
A) 1.9%.
B) 2.1%.
C) 2.7%.
D) 3.6%.

Question

Quizplus · Accepted Answer

The default premium compensates the investor for the risk of default. It is calculated as the expected loss due to default. With a 5% probability of default and a recovery rate of 75%, the expected loss is 5% * (1 - 75%) = 5% * 25% = 1.25%. Since the bond's yield to maturity is 12%, and part of this yield compensates for the expected loss, the default premium is the difference between the yield and the risk-free rate plus the expected loss. If we assume the risk-free rate plus expected loss does not fully account for the 12% yield (since the question does not provide a risk-free rate), the closest answer reflecting just the expected loss component is 1.9%, acknowledging that the actual calculation for the default premium might involve more information.

A Bond Has an Expected Yield-To-Maturity of 12% and a 5