Question

In​ mid-2009, Ralston Purina had​ AA-rated, six-year bonds outstanding with a yield to maturity of

3.98 %3.98%.

At the​ time, similar maturity Treasuries had a yield of

2 %2%.

a. If Ralston​ Purina’s bonds were​ risk-free, what is your estimate of the expected return for

these​ bonds?

b. If you believe Ralston​ Purina's bonds have

0.7 %0.7%

chance of default per year and that expected loss rate in the event of default is

32 %32%​,

what is your estimate of the expected return for these​ bonds?

Answer 1

a. If Ralston​ Purina’s bonds were​ risk-free, what is your estimate of the expected return for these​ bonds?

Yield to maturity of the Ralston Bond = 3.98%

b. If you believe Ralston​ Purina's bonds have 0.7% chance of default per year and that expected loss rate in the event of default is 32 % what is your estimate of the expected return for these​bonds?

Expected Return = Yield to maturity - Chance of default * Expected Loss

Expected Return = 3.98% - 0.70% * 32%

Expected Return = 3.7560%

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