Analysis of Credit Risk

CFA Level II Fixed Income
#1

In the Question:

A fixed-income trader at a hedge fund observes a 3-year, 5% annual payment corporate bond trading at 104 per 100 of par value. The research team at the hedge fund determines that the risk-neutral probability of default used to calculate the conditional POD for each date for the bond is 1.50% given a recovery rate of 40%. The government bond yield curve is flat at 2.50%.

Based on these assumptions, does the trader deem the corporate bond to be overvalued or undervalued? By how much? If the trader buys the bond at 104, what are the projected annual rates of return?

The exposure for Date 1 is calculated as:

5 + 5/(1.025) +105/(1.025)2 = 109.8186

Date 2 :

5/(1.0250)1+5/(1.0250)2+105/(1.0250)3=107.1401

Why wasnt the first coupon discounted?

#2

Because the exposure for Date 1 is calculated as of the end of the first year. So, since the first coupon is paid at the end of the first year, it is not discounted.

#3

Thank for the reply. Quick follow up question … But what about date 2 then shouldnt the exposure be calculated as of end of year 2?

#4

The date numbers here are not chronological, hence the confusion. Date 2 seems to be beginning of year so you are discounting the end of the year coupon and Date 1 seems to be end of year so you are not discounting the coupon.