The Following Information Relates to Questions
Lena Liecken Is

question 21

Multiple Choice

The following information relates to Questions
lena liecken is a senior bond analyst at taurus investment Management. Kristel Kreming,
a junior analyst, works for liecken in helping conduct fixed-income research for the firm's
portfolio managers. liecken and Kreming meet to discuss several bond positions held in the
firm's portfolios.
bonds i and ii both have a maturity of one year, an annual coupon rate of 5%, and a mar-
ket price equal to par value. The risk-free rate is 3%. historical default experiences of bonds
comparable to bonds i and ii are presented in exhibit 1.
EXHIBIT 1 Credit Risk Information for Comparable Bonds

$\begin{array}{lcc}&&\text { Percentage of Bonds That}\\&&\text { Survive and Make Full}\\\text { Bond } & \text { Recovery Rate } & \text { Payment } \\\hline \text { I } & 40 \% & 98 \% \\\text { II } & 35 \% & 99 \% \\\hline\end{array}$
Bond III
Bond III is a zero-coupon bond with three years to maturity. Liecken evaluates similar bonds and estimates a recovery rate of $38 \%$ and a risk-neutral default probability of $2 \%$ , assuming conditional probabilities of default. Kreming creates Exhibit 2 to compute Bond III's credit valuation adjustment. She assumes a flat yield curve at $3 \%$ , with exposure, recovery, and loss given default values expressed per 100 of par value.
$$\begin{array}{l}\text { EXHIBIT } 2 \text { Analysis of Bond III }\\\begin{array} { l c c c c c c c } \hline \text { Date } & \text { Exposure } & \text { Recovery } & \begin{array} { c } \text { Loss Given } \\\text { Default }\end{array} & \begin{array} { c } \text { Probability } \\\text { of Default }\end{array} & \begin{array} { c } \text { Probability } \\\text { of Survival }\end{array} & \begin{array} { c } \text { Expected } \\\text { Loss }\end{array} & \begin{array} { c } \text { Present Value } \\\text { of Expected } \\\text { Loss }\end{array} \\\hline 0 & & & & & & & \\1 & 94.2596 & 35.8186 & 58.4410 & 2.0000 \% & 98.0000 \% & 1.1688 & 1.1348 \\2 & 97.0874 & 36.8932 & 60.1942 & 1.9600 \% & 96.0400 \% & 1.1798 & 1.1121 \\3 & 100.0000 & 38.0000 & 62.0000 & \underline{1.9208 \% }& 94.1192 \% & \underline{1.1909} &\underline{ 1.0898} \\ \text { Sum } & & & & 5.8808 \% & & 3.5395 & 3.3367 \\\hline\end{array}\end{array}$$
Bond IV
Bond IV is an AA rated bond that matures in five years, has a coupon rate of $6 \%$ , and a modified duration of 4.2. Liecken is concerned about whether this bond will be downgraded to an A rating, but she does not expect the bond to default during the next year. Kreming constructs a partial transition matrix, which is presented in Exhibit 3, and suggests using a model to predict the rating change of Bond IV using leverage ratios, return on assets, and macroeconomic variables.
$$\begin{array}{l}\text { EXHIBIT } 3 \text { Partial One-Year Corporate Transition Matrix (entries in \%) }\\\begin{array} { l r c c } \hline \text { From/To } & \text { AAA } & \text { AA } & \text { A } \\\hline \text { AAA } & 92.00 & 6.00 & 1.00 \\\text { AA } & 2.00 & 89.00 & 8.00 \\\text { A } & 0.05 & 1.00 & 85.00 \\\text { Credit Spread (\%) } & 0.50 & 1.00 & 1.75 \\\hline\end{array}\end{array}$$
Default Probabilities

Kreming calculates the risk-neutral probabilities, compares them with the actual default probabilities of bonds evaluated over the past 10 years, and observes that the actual and risk-neutral probabilities differ. She makes two observations regarding the comparison of these probabilities:

Observation 1: Actual default probabilities include the default risk premium associated with the uncertainty in the timing of the possible default loss.

Observation 2: The observed spread over the yield on a risk-free bond in practice includes liquidity and tax considerations, in addition to credit risk.
-The expected exposure to default loss for bond i is:

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