The default state using available market data

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Reference no: EM13907542

You are currently doing research on Annex Corporation (symbol: ANX), a levered firm that appears to be financially distressed. Your goal is to infer the probability that this firm goes into default and the estimated bond repayment in the default state using available market data. The firm has two bonds outstanding: Bond A and Bond B. Bond A is senior to Bond B, meaning that it has first claim to the cash flows generated by the firm.

A) Bond B has a current price of $800, one year until maturity, a promised cash flow of $1,100 next year, and an expected return of 6 percent. If ANX defaults, then Bond B pays a cash flow of zero (this is because Bond A claims all available cash flows first). What is the probability of default implied by this information?

B) Bond A has a current price of $900, one year until maturity, a promised cash flow of $1,075 next year, and an expected return of 5 percent. The probability of default is given by your answer in part (A). Based on this information, what is the cash flow to Bond A in the default state? (the cash flow in the default state is also known as the recovery cash flow)

Reference no: EM13907542

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