Deck 23: Credit Risk and the Value of Corporate Debt

Question 1

The U.S. government agrees to guarantee a bond issue planned by Demurrage Associates (DA). The value of this guarantee
I.equals the value of the guaranteed loan minus the value of the loan without a guarantee;
II.is a subsidy to DA's equity investors;
III.is a windfall gain to the buyers of the bonds;
IV.equals the value of a put option on the firm's assets with an exercise price equal to the bond's promised payments

A)II only
B)I, II, and IV
C)I only
D)III only

Answer 1

I, II, and IV

Question 2

If the discount rate on a bond is 7 percent and the expected payment in year 1 is $952.50, calculate the price of the bond.

A)$1,050
B)$985
C)$890
D)$935

Answer 2

$890

Question 3

The value of a corporate bond can be thought of as

A)bond value without default - value of put.
B)bond value without default + value of put.
C)bond value without default + value of a stock.
D)bond value without default - value of call.

Answer 3

bond value without default - value of put.

Question 4

If the discount rate on a bond is 5 percent and the expected payment in year 1 is $985, calculate the price of the bond.

A)$1,050
B)$985
C)$938.10
D)$1,000

Question 5

A corporate bond matures in one year. The bond promises interest of $50 and principal of $1,000 at maturity. Suppose the bond has a 10 percent probability of default and payment under default is $400. If an investor buys the bond for $890.19, calculate the promised yield on the bond.

A)6.6 percent
B)18 percent
C)7 percent
D)10.7 percent

Question 6

Generally, you can insure corporate bonds through a(n)

A)arrangement with the Treasury department.
B)arrangement with the state government.
C)credit default swap.
D)back-dated options contract.

Question 7

The average yield spread based on promised yield on Aaa bonds rated by Moody's and the yield on Treasuries is about

A)1 percent.
B)2 percent.
C)3 percent.
D)4 percent.

Question 8

The value of a bond is given by
I.bond value = asset value - value of call option on assets
II.bond value = value of an equivalent default-free bond + value of put option on assets
III.bond value = value of an equivalent default-free bond + value of put option on the stock
IV.bond value = asset value + value of call option on the stock

A)I only.
B)I and II only.
C)III and IV only.
D)IV only.

Question 9

Suppose that a bond with one-year maturity, a coupon rate of 5 percent, and face value of $1,000 sells for $881.94. Calculate the promised yield on the bond.

A)5.42 percent
B)8.07 percent
C)19.06 percent
D)5.67 percent

Question 10

The interest rate on a one-year risk-free bond is 5 percent. BAC Company issued a 5 percent coupon bond with a face value of $1,000, maturing in one year. If the bond is considered risk-free, what is the price of the bond?

A)$1,050
B)$1,000
C)$985
D)$950

Question 11

The value of a corporate bond can be thought of as

A)asset value - value of call option on assets.
B)asset value + value of call option on assets.
C)asset value + value of a default-free bond.
D)asset value - value of put option on assets.

Question 12

What is the most important difference between a corporate bond and an equivalent U.S. Treasury bond?

A)Corporate cash flow is relatively smooth, whereas U.S. government revenue is more variable.
B)Corporate bonds are traded on the floor of the New York Stock Exchange, and Treasury bonds trade in the over-the-counter market.
C)In the case of corporate bonds, firms have sometimes defaulted, whereas the U.S. government has not.
D)The beta of corporate bonds is usually less than the beta of a U.S. Treasury bond.

Question 13

Which of the following rated bonds has the most risk?

A)Aaa
B)Aa
C)Baa
D)Ba

Question 14

The U.S. federal government has guaranteed loans to the following industries:
I.housing;
II.airlines;
III.ship owners and shipyards;
IV.steel companies;
V.oil and gas companies

A)I only
B)I and II only
C)I, II, III, and IV only
D)I, II, III, IV, and V

Question 15

A corporate bond matures in one year. The bond promises a coupon of $50 and principal of $1,000 at maturity. If the bond has a 10 percent probability of default and payment under default is $400, calculate the expected payment from the bond.

A)$1,050
B)$400
C)$985
D)$1,000

Question 16

A corporate bond matures in one year. The bond promises a $50 coupon and a principal payment of $1,000 at maturity. If an investor buys the bond for $938.10, calculate the promised yield on the bond.

A)6.60 percent
B)11.93 percent
C)5 percent
D)5.33 percent

Question 17

If the discount rate on a bond is 8 percent and the expected payment in year 1 is $952.50, calculate the price of the bond.

A)$1,050
B)$985
C)$907.14
D)$881.94

Question 18

A corporate bond matures in one year. The bond promises a $50 coupon and a principal payment of $1,000 at maturity.
If the bond has a 15% probability of default and payment under default is $400, calculate the expected payment from the bond.

A)$1,050.00
B)$400.00
C)$952.50
D)$892.50

Question 19

A corporate bond matures in one year. The bond promises a $50 coupon and principal of $1,000 at maturity. Suppose the bond has a 10 percent probability of default and payment under default is $400. If an investor buys the bond for $907.14, calculate the promised yield on the bond.

A)6.6 percent
B)15.75 percent
C)5 percent
D)8.58 percent

Question 20

Which of the following rated bonds has the least risk?

A)AAA
B)AA
C)A
D)BBB

Question 21

The median total debt ratio (Total debt/(total debt + equity in %)for industrial firms with an A rating is

A)12.4 percent.
B)28.3 percent.
C)37.5 percent.
D)38.6 percent.

Question 22

The value of a government guarantee of a bond equals the value of a put option on the firm's assets.

Question 23

Investors can insure corporate bonds through an arrangement called a credit default swap.

Question 24

Beaver, McNichols, and Rhie have developed the following model to predict the chance of failing during the next year relative to the chance of not failing for firms: log(relative chance of failure)= -6.445 - 1.192 ROA + 2.307 (liabilities/assets)- 0.346 (EBITDA/liabilities), using

A)multiple discriminant analyses.
B)real options analysis.
C)hazard analysis.
D)None of the options are correct.

Question 25

Floating-rate bonds have adjustable coupons to protect investors against changes in interest rates. The rates paid may be limited by

A)the put provisions of the issue.
B)a floor rate that sets the minimum.
C)a cap rate that sets the maximum.
D)both a floor rate that sets the minimum and a cap rate that sets the maximum.

Question 26

Generally, promised yields are at least as great as expected yields.

Question 27

Use the following data: ROA = 10%; Total liabilities = 90% of assets; EBITDA = 10% of liabilities. Calculate the relative chance of failure using the following model: Log (relative chance of failure)= -6.445 - 1.192 ROA + 2.307 (liabilities/assets)- 0.346(EBITDA/liabilities).

A)1.70 percent
B)1.09 percent
C)0.16 percent
D)None of the options are correct.

Question 28

The value of a risky bond equals value of a bond without default - value of a put option on assets.

Question 29

Commercial banks and several other financial institutions are not permitted to invest in bonds unless they are investment grade. What is the definition of an investment-grade bond?

A)One with a triple-A rating.
B)One with a rating of Baa or better.
C)One with a rating of B or better.
D)One with a rating of C or better.

Question 30

The three main bond rating agencies in the United States are
I.Moody's;
II.Standard and Poor's;
III.A.M. Best;
IV.Dominion Bond;
V.Fitch

A)I, II, and III
B)I, II, and IV
C)I, II, and V
D)II, III, and IV

Question 31

Generally, a corporate bond has a higher promised yield than the yield on a similar government bond.

Question 32

The value of a risky bond equals asset value - value of call option on assets.

Question 33

An analyst predicts that at the 95 percent confidence level a bank could lose 7 percent of its asset value. Given assets of $30 million, what is the value at risk?

A)$2.1 million
B)$27.9 million
C)$28.5 million
D)$30 million

Question 34

Bonds rated below BBB (Baa)are called

A)investment-grade bonds.
B)junk bonds.
C)default-free bonds.
D)intermediate bonds.

Question 35

Bonds rated below BBB (Baa)are termed junk bonds.

Question 36

During the period 1983-2012, the percentage of bonds that were rated AAA and remained AAA was

A)86.48 percent.
B)85.94 percent.
C)87.29 percent.
D)84.55 percent.

Question 37

It is extremely rare for a corporate bond to have a higher expected yield than a government bond.

Question 38

The default rate on B rated bonds 10 years after issue is less than (choose best response)

A)5 percent.
B)10 percent.
C)20 percent.
D)45 percent.

Question 39

The Z-score model was developed by Altman using

A)multiple discriminant analyses.
B)real options analysis.
C)hazard analysis.
D)None of the options are correct.

Question 40

In 2012, the Greek government strong-armed private investors into replacing their existing bonds with new securities worth what percentage of their original bonds?

A)30 percent
B)40 percent
C)50 percent
D)60 percent

Question 41

Briefly describe bond ratings.

Question 42

Briefly explain how governmental loan guarantees can be valued using the option pricing model.

Question 43

Briefly explain the term junk bonds.

Question 44

Define the term credit risk.

Question 45

Bonds rated BBB (Baa)and above are called junk bonds.

Question 46

Investment-grade bonds can usually be entered at face value on the books of banks and life insurance companies.

Question 47

Briefly explain the model developed by Beaver, McNichols, and Rhie to predict the chance of failure of a firm.

Question 48

Suppose that the possibility of default on a firm's bond is totally unrelated to other events in the economy. In this case, the beta of the bond will equal zero and the discount rate will equal the risk-free rate.

Question 49

What is a credit default swap? Briefly explain.

Question 50

Briefly explain how the option pricing model can be used for pricing risky debt.

Question 51

What is a major drawback to value-at-risk calculations?

Question 52

Briefly explain the term credit scoring.

Question 53

The value of a firm's right to default on a bond generally increases with the maturity of the bond.