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 0.72. There is also a (1-0.72) probability of paying back only $962. Current market conditions indicate a 2.5% risk-free rate of return and a 7.3% equity premium, and the bond has a beta of 0.2. What would you conclude is a fair CAPM market price, in dollars, for this bond?

Answer 1

Erpected Ratuin using After Year: Bond uritl faA5 (expecped) 862(1-0.72) $1060(042) + $923.36 = 1 039G

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