There Are Two Ratings in a Very Simple World: Non-Default $$Q = \left[ \begin{array} { c c } 0.90 & 0.10 \\0 & 1\end{array} \right]$$

question 3

Multiple Choice

There are two ratings in a very simple world: non-default (ND) and default (D) .The risk-neutral rating transition matrix per year is given by: $$Q = \left[ \begin{array} { c c } 0.90 & 0.10 \\0 & 1\end{array} \right]$$ i.e. ,the probability of defaulting when the current state is non-default is 0.10,and a defaulted bond never leaves that state and has zero recovery.The three-year zero-coupon risk-free rate is 4% (continuously-compounded) .The price of a default-risk-bearing three-year unit face value zero-coupon bond is:

• A)0.55
• B)0.60
• C)0.65
• D)0.70

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Definitions:

Yield To Maturity

The total return anticipated on a bond if it is held until its maturity date, including all interest payments and capital gains or losses.

Rate Of Return

Profitability or loss incurred from an investment within a fixed period, quantified as a percentage of the investment's buying cost.

Credit Default Swap

A financial derivative allowing an investor to "swap" or offset their credit risk with that of another investor.

CDS

CDS stands for Credit Default Swap, a financial derivative allowing an investor to "swap" or offset their credit risk with that of another investor.