B18) (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the $1,000 principal in 10 years. You pay only $500 for the bond.

a) You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years. What is the realized return on your investment?
b) The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment?

To calculate the realized return on your investment in each scenario, we need to determine the total cash flows received and the holding period. The realized return can then be calculated using the formula:

Realized Return = (Total Cash Flows / Investment Cost)^(1 / Holding Period) - 1

a) In this scenario, you receive coupon payments for three years and then the bond defaults. After liquidation, you receive a distribution of $150 per bond at the end of 3.5 years.

Total cash flows received:
- Coupon payments for three years (9.5% * $1,000 * 3) = $285
- Distribution after liquidation = $150

The investment cost is $500, and the holding period is 3.5 years.

Realized Return = (($285 + $150) / $500)^(1 / 3.5) - 1

b) In this scenario, the firm does well and you receive all of the promised interest and principal payments.

Total cash flows received:
- Coupon payments for ten years (9.5% * $1,000 * 10) = $950
- Principal payment at maturity = $1,000

The investment cost is $500, and the holding period is 10 years.

Realized Return = (($950 + $1,000) / $500)^(1 / 10) - 1

Using these formulas, you can calculate the realized return on your investment in each scenario.