The expectation is that a Greek default is imminent. Last week, the yield on Greek 1 year bonds was a mind-blowing 61%. On Friday, it jumped to 72%. Now it is at 83% and climbing rapidly. The 2 year yield is now over 50%.
This could be a question on a finance exam. Assuming an investor would want 2% return on a no-risk investment, and Greece is certain to default but not immediately, what would be the expected date of a Greek default? Assume interest is accrued monthly.
For the 2 year bonds, this is 18 months, because at that point the interest earned would fully repay the initial investment.
For the 1 year bonds, this is 11 months.
What if the bonds will be worth 50% of face value after a default, what then?
For 2 year bonds, 11 months.
For 1 year bonds, 7 months.
What about a higher value, say 70%?
For 2 year bonds, 7 months.
For 1 year bonds, 5 months.
What about 10 year bonds, now priced at 19.4%?
If they will be worth 50% after default, then a default is expected in 26 months.
If they will be worth 70% after default, then 17 months.
If no remaining value, then 44 months.
If it is true that a default is imminent, then even 83% interest isn't high enough. Assuming 70% residual value and default would occur in 1 month, then what interest rate is appropriate? Answer: 360% interest. This would provide $30 of interest to make up for the 30% haircut.
Assume that the 1 year bond pays no interest, and will pay $100 on maturity. How much would you pay for it to get an effective interest rate of 83% (with interest accrued monthly)? Answer: $47.
What about a 2 year bond, with an interest rate of 50%, accrued monthly, that pays no interest? $38.
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