Question

Suppose you have $10,000 to invest. A broker phones you with some information you requested on certain junk bonds. If the company issuing the bonds posts a profit this year, it will pay you a 40 percent interest rate on the bond. If the company files for bankruptcy, you will lose all you invested. If the company breaks even, you will earn a 10 percent interest rate. Your broker tells you there is a 50 percent chance that they will break even and a 20 percent chance that the company will file for bankruptcy. Your other option is to invest in a risk-free government bond that will guarantee 8 percent interest for 1 year. A) What is the expected interest rate (rate of return) for the junk bond investment

Answer 1

Answer:

the expected rate of return of the junk bond = 17%

Explanation:

the expected rate of return of the junk bond = (return if the company makes a profit x probability of the company making a profit) + (return if the company makes goes bankrupt x probability of the company going bankrupt) + (return if the company breaks even x probability of the company breaking even)

the expected rate of return of the junk bond = (40% x 0.3) + (0 x 0.2) + (10% x 0.5) = 12% + 0 + 5% = 17%