Question

Short Term Inc. has issued zero-coupon bonds that mature in one year. The returns from holding these bonds have a beta of 0.25. There is a chance of 70% that the bonds will pay full value, and a chance of 30% that they will only be worth 60 cents for each dollar of face value.Assume that the CAPM holds, that the riskless rate is 5% and that the expected return on the market is 15%.1) What is the current price of the bonds, per $100 face value?2) What is the yield to maturity on the bonds?3) What is the expected return on the bonds?

Answer 1

1. Current bonds price = $81.86.

2. Yield to maturity = 22.16%.

3. 3. Expected Return = 7.5%.

Step-by-step explanation:

Required Rate = Rf + beta*MRP

= 5% + 0.25*(15% - 5%)

= 5% +0.25*10%

= 5% + 2.5% = 7.5%

Required Rate = 7.5%

Expected Future Value = 70% x $100 + 30% x $60

= (0.7*$100) + (0.3*$60)

= $(70+18) = $88

Expected Future Value = $88

1. Current bonds price = 88/1.075 = $81.86

2. Yield to maturity = 100/81.86 - 1 = 1.22159785-1 = 0.22159785 = 22.159785% = 22.16%

3. Expected Return = 7.5%