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Question 1-Fixed Income: Answers (30 Points) : BBB B Default, BBB BB Default, With Probability A BB Default

1) The document discusses the default risk, spread risk, and liquidity risk of corporate bonds from an automaker company. 2) It calculates the probability of the company defaulting within three years to be 0.0064% based on possible rating downgrade pathways and probabilities. 3) It provides an example of calculating the yield, price, and negative 0.722% rate of return of a 2-year BBB rated bond from the company based on its spread over government bonds. 4) The expected rate of return across different rating scenarios is calculated to be a positive 0.453% based on probability-weighting the returns for each rating.

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15 views2 pages

Question 1-Fixed Income: Answers (30 Points) : BBB B Default, BBB BB Default, With Probability A BB Default

1) The document discusses the default risk, spread risk, and liquidity risk of corporate bonds from an automaker company. 2) It calculates the probability of the company defaulting within three years to be 0.0064% based on possible rating downgrade pathways and probabilities. 3) It provides an example of calculating the yield, price, and negative 0.722% rate of return of a 2-year BBB rated bond from the company based on its spread over government bonds. 4) The expected rate of return across different rating scenarios is calculated to be a positive 0.453% based on probability-weighting the returns for each rating.

Uploaded by

jacch123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Question 1- Fixed income: Answers

(30 points)

a)
 Default risk of the company
 Spread risk: risk of change in the spread due to changes in ratings or new information
regarding the company, or due to changes in the conditions of the bond market.
 Liquidity risk: risk that liquidity is not as envisioned when trading becomes necessary

b)
Following table 1, the automaker company cannot go bankrupt before three years time
[because at worst during the first two years we have: T=0: AA, T=1: BBB, T=2: B]. The
possible paths of ratings towards default are:
AABBBBDefault,

with probability

1% 1% 35%=35(%)3

AABBBBBDefault,

with probability

1% 20% 1%=20(%)3

with probability
9% 1% 1%=9(%)3
AAABBDefault,
Total probability of default = [35+20+9](%)3 = 64(%)3 = 0.0064%
c)
The yield on a 2-year government bond is 3% and the spread for a 2-year BBB rated
bond is 90 bp, therefore the yield on the bond is 3.90%. With an annual coupon of 2.3%
(annual payment) and 2 years to maturity, the bond price is:
2 .3
102.3
P=
+
96.978
1.039 1.039 2
(2.3 + 96.98) 100
The rate of return on investment is:
0.722%
100
d)
The expected rate of return is calculated as rating-probability-weighted average of the
rate of return in one year for each rating:
Rate of return
AAA rating
AA rating
A rating
BBB rating

Probability
0.677%
0.489%
0.207%
-0.722%

1%
89%
9%
1%

0.01 0.677% + 0.89 0.489% + 0.09 0.207% + 0.01 (-0.722%) = 0.453%


e)
For example, following factors would be adequate:
 Corporate bonds have a liquidity premium because they are less liquid than
government bonds
 There is a risk premium for fluctuations in the rate of return due to changes in rating

or default
 There is a premium because of uncertainty over the ratings and default forecasts
themselves
 It is possible that the XYZ Credit Analysis Team's forecast is different from the
market's
 The automaker Companys bond may have a higher potential for downgrading or
default than the ratings change forecast indicates

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