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You have opportunities to invest in 2 catastrophic bonds with 1-year maturity
You have opportunities to invest in 2 catastrophic bonds with 1-year maturity. The first bond offers 8% annual rate of return, and the catastrophic triggering event forfeiting all principal and interest has the probability of 2%. The second bond offers 6% annual rate of return, and the triggering event forfeiting all principal and interest has the probability of 1%. If you invest 60% of your wealth in the 1st bond and 40% in the 2nd bond, what is your expected return?
Expert Solution
Answer:
Lets assume the price and face value of the bond be the 100.
Calculation of retun on 1st Bond.
There is probability of 2% that bond principle and interest will be forfeited.
Expected Retunr = ( ( ( ( 8+100)*98% ) / 100 ) - 1 ) * 100 = 5.84%
Calculation of return on 2nd Bond.
There is is probability of 1% that bond principle and interest will be forfeited.
Expected Return = ( ( ( ( 6+100)*99% ) / 100 ) -1 ) * 100 = 4.94%
Expected retun if we invest 60% in 1st bond and 40% in 2nd Bond
Expected return = 5.84% * 60% + 4.94% * 40% = 5.48%
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