See the example in the course notes given on page 16 of Chapter 3. Can anyone explain this? I can't work it out at all. Investor A buys risky bond B (let's say at £80 for £100 nominal), then pays the coupons to Bank C in return for LIBOR + 2% (on what principal? - would surely be less than £80 assuming risk-free, so let's say it's risky and the principal is £80), and at maturity (assuming bond B doesn't default) pays the capital gain - effectively £100 less purchase price, so £20. So, net, he gets his purchase price back. So he could instead have invested his £80 in a (risky) investment that paid LIBOR + 2%, and got his £80 back at the end (assuming this alternative risky investment didn't default). I think I've assumed that overall the value is zero initially: each (risky) investment was worth £80 at outset. However: We are told that, on default of bond B, Investor A receives a net (£100 less recovery). I can't see how this relates at all to the total return on the alternative investment (LIBOR + 2% plus £80 principal, assuming it doesn't default, or whatever if it does). Can anyone tell me which point (or points, or whole principles!) I am missing?! Thanks!
Answering my own question... Further reading suggests that the payment to A on default of bond B should still be the LIBOR + 2% until the end of the contract (which isn't necessarily the maturity date of bond B - it could be before maturity), then the return of the market price of the bond B at outset (rather than the face value), while A pays to C whatever is recovered from B when it's recovered. So I think the reading is wrong here (or I have fundamentally misinterpreted it). And, the more I look at it, the margin above LIBOR must reflect the credit risk of dealing with bank C (which is what I think I was assuming). Any comments, anyone?
