Question

Problem 6. You are looking to estimate the risk-free rate in the Dinadian dollar, the currency of Dinada. You are concerned that the probability of default of the Dinadian government is not 0 . You have the following information: a. The rate on a 10-year zero coupon bond issued by the Dinadian government in Dinadian dollars is 10%. b. The rate on a 10-year zero coupon bond issued by the US Government in US dollars is 3%. c. The rate on a 5 -year coupon bond issued by the Dinadian government in US dollars is 8%. 5 d. The Dinadian government's local currency credit rating is C. e. The default spread of C-rated government bonds is 4%.

Answer 1

To estimate the risk-free rate in Dinadian dollars, we need to adjust the yield on the Dinadian government bond to account for the probability of default. We can use the default spread and the credit rating of the Dinadian government to estimate this.

The default spread is given as 4%, which represents the additional yield required for a C-rated government bond compared to a risk-free bond. Therefore, we can calculate the adjusted yield on the Dinadian government bond as:

Adjusted yield = Yield on Dinadian government bond + Default spread

Using the given information:

Yield on Dinadian government bond = 10%

Default spread = 4%

Adjusted yield = 10% + 4% = 14%

Therefore, the estimated risk-free rate in Dinadian dollars, considering the probability of default, is 14%.

Please note that estimating the risk-free rate involves various assumptions and considerations, and the calculation provided is a simplified approach based on the given information. In practice, determining the risk-free rate may involve a more comprehensive analysis and consideration of additional factors.

To know more about