Consider a $1,000-par junk bond paying a 12% annual coupon with two years to maturity. The issuing company has a 20% chance of defaulting this year; in which case, the bond would not pay anything. If the company survives the first year, paying the annual coupon payment, it then has a 25% chance of defaulting in the second year. If the company defaults in the second year, neither the final coupon payment nor par value of the bond will be paid.
a. What price must investors pay for this bond to expect a 10% yield to maturity?
b. At that price, what is the expected holding period return and standard deviation of returns? Assume that periodic cash flows are reinvested at 10%.
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