A U.S. company has previously issued a dual currency bond that pays coupons in euros and principal in yen. A major subsidiary of the company is based in Germany and receives euro- denominated payments. The current price on the bond is 80 with a 20% probability of default. The anticipated recoverate is 60%. Which of the following statements is correct? Assume the interest rate is zero.
A. The company faces wrong-way risk; risk-neutral loss rate equals 8%.
B. The company faces wrong-way risk; risk-neutral loss rate equals 20%.
C. The company faces right-way risk; risk-neutral loss rate equals 8%.
D. The company faces right-way risk; risk-neutral loss rate equals 20%.
Answer:D
The company faces right-way risk since the euro exposure is partially hedged (it pays euros on its debt but receives euros from sales).
risk-neutral mean loss rate = 1-80/1000 = 20%
mean loss rate = PD LGD = (0.2) (1-0.6) = 8%