FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies
A fund buys distressed bonds at 40 per 100 face. It assumes a 70% chance of a recovery of 65 in two years and a 30% chance of a recovery of 15 in three years. Using a 15% annual discount rate, what is the approximate expected present value of the bond, and does it exceed the 40 price?
Discounting gives about 37.4, so the bond appears modestly overpriced at 40.
- AAbout 36.9; no, it is below the price
- BAbout 40.4; roughly equal to the priceCorrect
- CAbout 43.9; yes, it exceeds the price
- DAbout 51.0; yes, it exceeds the price
Explanation
PV of 65 in two years = 65/1.3225 = 49.15. PV of 15 in three years = 15/1.5209 = 9.86. Expected PV = 0.7*49.15 + 0.3*9.86 = 34.41 + 2.96 = 37.37. This is nearer to 37.4, so none of the listed values is exact; check carefully.
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