Question

You are evaluating a one year zero coupon bond, which you estimate has a 5 percent default probability. The current risk free rate is 2 percent. In case of default, similar bonds usually recover 41 pennies on the dollar owed. What rate of return would you require, at a minimum, on this investment? Enter answer in percents, accurate to two decimal places. The answer has to be 5.1. Please show all the steps.

Answer 1

Rate of return = Risk free rate + Loss% * Default probability%/(1- Default probability%)

= 2% + 59%* 5%/(1-5%) = 5.11%

Loss% = (1 - .41) = .59 or 59%