General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market today of 97.5 dollars. The zero-coupon bond pays 100 dollars in exactly one year from now. To be precise, General Motors promises to pay 100 dollars in one year's time. Of course, there is the possibility that General Motors may default on its promised payment. In the event of default, liquidators would be appointed to seil off General Motors's assets and then distribute the proceeds to bond-holders so they get some of their money back. Analysts estimate (and we accept their estimate as fact) that General Motors's assets will generate a payment of S60, per every $100 promised, in one year's time in the event of General Motors defaulting. General Motors's bonds trade freely in the market and you can sell them short if you have to (without any extra costs). You can also borrow or lend risk-free at 2% per annum (continuously compounded). There are no transactions costs. You are vworking as a trader at Morgan Stanley (a prestigious Wall Street Investment Bank). You get a phone call from a customer who has significant exposure to the risk of General Motors defaulting and she is really worried about this. She needs a hedge and she doesn't mean the gardening typel She asks if, today, you will sell her a security to help her hedge her default risk. She wants to buy a security (let us call it a DIGITAL DEFAULT contract) from you today which pays nothing at all if General Motors does NOT default but will pay her 100 dollars exactly one year from now if General Motors does default (in essence, she wants to buy a kind of insurance contract) in the intervening time period. The aim of this question is to establish at what price should you sell this DIGITAL DEFAULT contract to your customer. You assu me the absence of arbitrage. a) Set up a portfolio consisting of a short position in the DIGITAL DEFAULT contract and a position in the General Motors's bond which is risk-free to Morgan Stanley. I want you to be explicit about this portfolio (long? short? how many?) (4 marks) b) What is the value (correct to 5 decimal places) of this portfolio in dollars in one year's time? (1 mark) c) What is the value (correct to 5 decimal places) of this portfolio in dollars today? (1 mark) d) In the absence of arbitrage, and using your answer to part (c), at what price (in dollars and correct to 4 decimal places) would you sell the DIGITAL DEFAULT contract to your customer? (4 marks) e) By using the risk-neutral valuation principle, check your calculation in part (d). What is the risk- neutral probability of General Motors defaulting (correct to 4 decimal places)? (2 marks) General Motors has isued a zero-coupon bond. The zero-coupon bond has a price in the market today of 97.5 dollars. The zero-coupon bond pays 100 dollars in exactly one year from now. To be precise, General Motors promises to pay 100 dollars in one year's time. Of course, there is the possibility that General Motors may default on its promised payment. In the event of default, liquidators would be appointed to seil off General Motors's assets and then distribute the proceeds to bond-holders so they get some of their money back. Analysts estimate (and we accept their estimate as fact) that General Motors's assets will generate a payment of S60, per every $100 promised, in one year's time in the event of General Motors defaulting. General Motors's bonds trade freely in the market and you can sell them short if you have to (without any extra costs). You can also borrow or lend risk-free at 2% per annum (continuously compounded). There are no transactions costs. You are vworking as a trader at Morgan Stanley (a prestigious Wall Street Investment Bank). You get a phone call from a customer who has significant exposure to the risk of General Motors defaulting and she is really worried about this. She needs a hedge and she doesn't mean the gardening typel She asks if, today, you will sell her a security to help her hedge her default risk. She wants to buy a security (let us call it a DIGITAL DEFAULT contract) from you today which pays nothing at all if General Motors does NOT default but will pay her 100 dollars exactly one year from now if General Motors does default (in essence, she wants to buy a kind of insurance contract) in the intervening time period. The aim of this question is to establish at what price should you sell this DIGITAL DEFAULT contract to your customer. You assu me the absence of arbitrage. a) Set up a portfolio consisting of a short position in the DIGITAL DEFAULT contract and a position in the General Motors's bond which is risk-free to Morgan Stanley. I want you to be explicit about this portfolio (long? short? how many?) (4 marks) b) What is the value (correct to 5 decimal places) of this portfolio in dollars in one year's time? (1 mark) c) What is the value (correct to 5 decimal places) of this portfolio in dollars today? (1 mark) d) In the absence of arbitrage, and using your answer to part (c), at what price (in dollars and correct to 4 decimal places) would you sell the DIGITAL DEFAULT contract to your customer? (4 marks) e) By using the risk-neutral valuation principle, check your calculation in part (d). What is the risk- neutral probability of General Motors defaulting (correct to 4 decimal places)? (2 marks)
Expert Answer:
Answer rating: 100% (QA)
a From the question we must determine the probability of default However we are not provided with so ... View the full answer
Related Book For
Auditing a business risk appraoch
ISBN: 978-0324375589
6th Edition
Authors: larry e. rittenberg, bradley j. schwieger, karla m. johnston
Posted Date:
Students also viewed these accounting questions
-
A refrigerator manufacturer, Zero King, issued a zero coupon bond with 10 years to maturity. What is the yield-to-maturity of this bond if it is sold for $352?
-
You purchased a zero coupon bond one year ago for $109.83. The market interest rate is now 9 percent. If the bond had 25 years to maturity when you originally purchased it, what was your total return...
-
You purchased a zero coupon bond one year ago for $425.32. The market interest rate is now 4.3 percent. If the bond had 20 years to maturity when you originally purchased it, what was your total...
-
What will be the sum of third proportional to 18 and 54 and fourth proportional to 12, 18 and LCM of 12 and 18? 1. 162 2. 216 3. 612 4. 256 526 5.
-
Demonstrate the equivalence of regression with dummy variables to one-way ANOVA.
-
The Clarkson Company recently reported net profits after taxes of $15.8 million. It has 2.5 mil-lion shares of common stock outstanding and pays preferred dividends of $1 million a year. The companys...
-
Explain the steps for the discovery of use cases.
-
On October 2, 2011, Flx, a U.S. company, entered into a forward contract to purchase 50,000 euros for delivery in 180 days at a forward rate of $0.6350. The forward contract is a derivative...
-
Pauley Company needs to determine a markup for a new product. Pauley expects to sell 35,000 units and wants a target profit of $22 per unit. Additional information is as follows: Variable product...
-
Grove Audio is considering the introduction of a new model of wireless speakers with the following price and cost characteristics. Required a. What number must Grove Audio sell annually to break...
-
The Student Homework Done!, is a global & favorite student homework/assignment/project/thesis outsourcing entrepreneur startup, that is seeking to increase its working capital by $ 75 million....
-
and 10 B=0,+r cosa,+a, in cartesian and cylindrical coordinates Express the vector and find B=(-3,4,0) Two blocks of masses 10kg and 20kg are placed on the x-axis. The first mass is moved on the axis...
-
Using the Black-Scholes option pricing model, determine the following: a) the value of the call option; b) value of the put option. What is the value of the put option using the put-call parity?...
-
Sturm-Liouville theorem states that for ODE of the following form (p(x)y')' + [q(x) + Aw(x)]y = 0 Suppose ym(x) and yn(x) are solutions satisfying certain boundary condition to this ODE with...
-
Suppose we have a perfectly competitive coal market and suppose that demand and supply in this market are given by the following functions: Qa=18. 8-1/P 1 Q = 6+ = P a. Determine the equilibrium...
-
It is March 1st, 2023, and you CPA who work for the firm of Richards Stern LLO has been asked to review the audit working papers and draft audited financial statements of Bestyear Tires (BT), a...
-
During a period, an RV company purchased three vehicles for $33,000, $46,000, and $24,000, and sold two of them for a total of $125,000. Using the specific identification method of costing inventory,...
-
Match the following. Answers may be used more than once: Measurement Method A. Amortized cost B. Equity method C. Acquisition method and consolidation D. Fair value method Reporting Method 1. Less...
-
In what ways is the auditing profession uniquely qualified to expand into the broader arena of assurance services?
-
You are auditing FloorMart, a retailer with 200 stores around the country. It has two basic sizes of storesminimarts with 3,000 square feet and maxim arts with 7,500 square feet. Both types of stores...
-
The Sarbanes-Oxley Act dramatically changes the responsibilities of top management. Required a. Briefly indicate how Sarbanes-Oxley changes the responsibilities of top management. b. How has the...
-
Determine whether each of the following statements is true or false: Management accountants should be technically proficient, but they dont need strong oral and written communication skills.
-
Determine whether each of the following statements is true or false: Management accountants are now more often looked upon as internal business advisors rather than bean counters recording historical...
-
Determine whether each of the following statements is true or false: The Association of International Certified Professional Accountants (AICPA) issues the Certified Management Accountant (CMA)...
Study smarter with the SolutionInn App