Explanation:
Step 1: Calculate Expected Price Change Due to Rating Migration
Expected return = YTM + Expected price change due to rating migration
Price change ≈ -Modified Duration × Change in credit spread
Step 2: Calculate Expected Change in Credit Spread Expected Δspread = Σ[Probability × (New spread - Current spread)]
Current BB spread = 3.20%
Expected Δspread =
Total Expected Δspread = -0.05852% - 0.07560% + 0% + 0.30020% = 0.16608%
Step 3: Calculate Expected Price Change Expected price change ≈ -6.52 × 0.16608% = -1.082%
Step 4: Calculate Expected Return Expected return = 4.25% - 1.082% = 3.168% ≈ 3.17%
The expected return is closest to 3.17%, which matches option A.
Ultimate access to all questions.
An analyst gathers the following information on the following partial 1-year transition matrix for BB rated bonds and credit spread data:
| Probability (%) | A | BBB | BB | B |
|---|---|---|---|---|
| 2.66 | 4.20 | 85.24 | 7.90 | |
| Credit spread | 1.00% | 1.40% | 3.20% | 7.00% |
Assuming no default, the 1-year expected return on a BB rated bond with a YTM of 4.25% and a modified duration of 6.52 is closest to:
A
3.17%.
B
4.25%.
C
5.33%.
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