1. The credit spread is the difference in YTM between corporate bonds and Treasury bonds of similar maturities. Explain why the credit spread correlates closely with stock volatility across time. (10 points)

2. You have collected information about firm XYZ as follows: The debt of the firm: par value = $800, annual coupon = $100 (paid once a year), maturity = 3 years. The total value of the firm (including equity and the debt) = $1,000 now. The firms future values follow a two-state path with Up state growth multiple u = 1.3 and Down state growth multiple d = 0.769 each year. The annual risk-free rate = 2%. (a) What is the value of the firms debt, if it is a straight corporate debt? (25 points) (b) Suppose now that instead of a straight corporate debt as in (1), the firms debt is convertible for 40% of the firms value. What is the value of the convertible corporate debt? (15 points) (c) There is a Treasury bond with the par value of $800, annual coupon of $100, and the maturity of 3 years. Suppose that the term structure of spot rates is flat at 2%. What is the value of the Treasury bond? (10 points) (d) Which bond, the Treasury bond or the straight corporate bond, has higher price and why? Calculate the credit spread, which is the difference in yield between the straight corporate bond and the Treasury bond (20 points) (e) Which bond, the straight corporate bond or the convertible corporate bond, has higher price and why? (10 points)