At the time the government of Bulgrovia issued new bonds, they issued them at a price that reflected the risk-free rate because investors had no concerns regarding default risk, so did not require a risk premium. That risk-free rate was 4%. These bonds currently have one year to maturity and you notice the yield is 20%. Can you calculate the probability that the Bulgrovian government will default?
What will be an ideal response?
The simple answer is no. A risk-premium is a measure of the premium required by investors to accept risk; it is not a direct measure of the risk of default. We could only determine this if investors are risk-averse. If that were true then, we can calculate the probability fairly easily by realizing the probability the bond will not default can be expressed by 1.04/1.20, which equals 0.867. If we subtract this from 1.0 we obtain the probability of default which is 0.133.
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What will be an ideal response?