First Fidelity has asked you to bid for a zero coupon loan portfolio A with a term of 5 years. Their internal controls suggest it has a 90% chance of a paying $100.00 at maturity and a 10.00% chance of a paying $90.00. City Mutual recently sold a similar term loan portfolio B which you estimated as having a 60% chance of a paying $100.00 at maturity and a 40.00% chance of $90.00 for $71.46. If the 5 year risk free rate is 5% and your required risk premium p.a. is...
i) What is the maximum you would pay for portfolio A?
ii) If you think that the probability of the downside outcome is 10% higher for A what would you offer?
iii) Would a guarantee of First Fidelity's internal ratings be worth having at a cost of $0.50?
iv) Would you have paid more than the market for portfolio B?
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