Question

A $1,000 municipal bond is in danger of default, and you are a bond-holder trying to sell the asset at a fair price. The municipality is facing uncertainty in the face of decreasing tax revenues, but is expected to repay the bond in its entirety with probability 0.71. There is also a (1-0.71) probability of paying back only $950. Current market conditions indicate a 6% risk-free rate of return and a 5.7% equity premium, and the bond has a beta of 0.3. What would you conclude is a fair CAPM market price, in dollars, for this bond?

Answer 1

The solution to the given question is provided below for your reference

Fair Price of the bond=(1000*0.71+950*(1-0.71))/(1+6%+0.3*5.7%)=914.9568285