6. (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the
$1,000 principal in 10 years. You pay only $500 for the bond.
a. You receive the coupon payments for three years and the bond defaults. After liquidating
the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years.
What is the realized return on your investment?
The bond is valued at $1,000, and has a .095 coupon rate. The bond should be redeemed in 10 years,
and you paid only $500 for it.
Coupon payments:
Year 1: 1,000 x .095 = 95
Year 2: 95
Year 3:95
Total coupon payments: 285
Bondholder distribution: 150
Total received payments: $435
For ROI: profit x 100/ investment x years invested
(435 - 500) x 100 / (500 x 3.5) = -6500/ 1750 = -3.71% realized return on investment
b. The firm does far better than expected and bondholders receive all of the promised
interest and principal payments. What is the realized return on your investment?
If the firm did not default and payed out all interest and principle:
Interest revenue: 1,000 x .095 x 11 = 1,045
Principle: 1,000
Total received: 2,045
Investment: 500
ROI: (2045 - 500) x 100 / (500 x 11) = 154,500 / 5,500 = 28.09% realized return on investment.