Lori Boller is a fixed-income money manager specializing in taking long positions on high-yield corporate bonds that
Question:
Lori Boller is a fixed-income money manager specializing in taking long positions on high-yield corporate bonds that she deems to be undervalued. In particular, she looks for bonds for which the credit spread over government securities appears to indicate too high a probability of default or too low a recovery rate if default were to occur. Currently, she is looking at a three-year, 4.00% annual payment bond that is priced at 104 (per 100 of par value). In her opinion, this bond should be priced to reflect an annual default probability of 2.25% given a recovery rate of 40%. Ms. Boller is comfortable with an assumption of 10% volatility in government bond yields over the next few years. Should she consider buying this bond for her portfolio? Use the government par curve in Exhibit 9 and the binomial interest rate tree in Exhibit 10 in the solution.
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