(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
a. To calculate the realized return on your investment, you need to consider the cash flows you received and the final distribution after the bond defaulted.
First, let's calculate the cash flow from the coupon payments. You received coupon payments of 9.5% * $1,000 = $95 per year for 3 years. So the total cash flow from the coupon payments is $95 * 3 = $285.
Next, let's calculate the final distribution after the bond defaulted. You received a distribution of $150 per bond after 3.5 years. Since you bought the bond at $500, this distribution of $150 reduces your investment by $500 - $150 = $350.
Now, let's calculate the realized return. The realized return is the total cash flow received divided by the initial investment.
Total cash flow received = Coupon payments + Final distribution = $285 + $150 = $435
Initial investment = Price paid for the bond = $500
Realized return = Total cash flow received / Initial investment = $435 / $500 = 0.87 or 87%
Therefore, the realized return on your investment is 87%.
b. In this scenario, the firm does better than expected and bondholders receive all of the promised principal of $1,000 at the end of 10 years. Since there was no default and you received the full promised principal, the realized return on your investment would be just the coupon payments.
The coupon payments were $95 per year for 10 years. So the total cash flow from the coupon payments would be $95 * 10 = $950.
Initial investment = Price paid for the bond = $500
Realized return = Total cash flow received / Initial investment = $950 / $500 = 1.9 or 190%
Therefore, the realized return on your investment would be 190% in this scenario.