Question

In​ mid-2012, Ralston Purina had​ AA-rated, 10-year bonds outstanding with a yield to maturity of 1.97 %. a. What is the highest expected return these bonds could​ have? b. At the​ time, similar maturity Treasuries had a yield of 0.97 %. Could these bonds actually have an expected return equal to your answer in part ​(a​)? c. If you believe Ralston​ Purina's bonds have 1.2 % chance of default per​ year, and that expected loss rate in the event of default is 49 %​, what is your estimate of the expected return for these​ bonds? a. What is the highest expected return these bonds could​ have? The highest expected return these bonds could have is _______% ​(Round to two decimal​ places.) b. At the​ time, similar maturity Treasuries had a yield of 0.97 %. Could these bonds actually have an expected return equal to your answer in part ​(a​)? ​ (Select the best choice​ below.) A. ​No, if the bonds are​ risk-free, the expected return equals the​ risk-free rate, and if they are not​ risk-free the expected return is less than the yield. B. ​Yes, the yield to maturity is the maximum expected return you can expect. C. ​Yes, if the bonds are risky​ enough, that is if the probability of default is high enough. D. ​Yes, because the reasons given in both A. and B. are true. c. If you believe Ralston​ Purina's bonds have 1.2 % chance of default per​ year, and that expected loss rate in the event of default is 49 %​, what is your estimate of the expected return for these​ bonds? The estimated expected return for these bonds will be _______% ​(Round to two decimal​ places.)

Answer 1

Answer a:

Given:

Ralston Purina had? AA-rated, 10-year bonds outstanding with a yield to maturity of 1.97 %.

As such,

The highest expected return these bonds could have is = 1.97%

Answer b:

At the? time, similar maturity Treasuries had a yield of 0.97 %, Could these bonds actually have an expected return equal to your answer in part ?(a?)

Best choice is :

A. ?No, if the bonds are? risk-free, the expected return equals the? risk-free rate, and if they are not? risk-free the expected return is less than the yield.

'Choice B' cannot be best choice as the question is on 'expected return' not 'maximum return' when risk free return (similar maturity Treasuries had a yield) is 0.97 %.

'Choice C' is incorrect since if the bonds are risky? enough, expected return will be less than the yield.

As 'Choice B' and 'Choice C' are not correct choices, hence 'Choice D' is also not the correct choice.

Answer c:

If Ralston? Purina's bonds have 1.2 % chance of default per? year, and that expected loss rate in the event of default is 49 %?, the estimated expected return for these? bonds:

Given, chance of default = 1.2%

Hence, chance of success = 100% - 1.2% = 98.8%

On default, loss % = 49%

On succes, return/gain = 1.97%

The estimated expected return for these bonds will be 1.36%