Return of Investing (ROI)

Question 1. (Total 30 Marks)
A five-year 2.4% defaultable coupon bond is selling to yield 3% (Annual Percent Rate and semi-annual
compounding). The bond pays interest semi-annually. The risk-free yield is 2.4%. Therefore, its current
credit spread is 3% – 2.4% = 0.6%. Two years later its credit spread increases from 0.6% to 1% while
the risk-free yield doesn’t change. Assuming the face value of the coupon bond and risk-free bond is
a) What is the return of investing in this bond over the two year? (10 marks)
b) If we define credit value as the difference between the prices of risk-free bond and defaultable
bond, what is the current credit value of the bond, and what is it after two years? (10 marks)
c) Decompose the return into two components attributable to moving to maturity and the
increase in the credit spread. (10 marks)

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