Deck 23: Credit Risk and the Value of Corporate Debt

Question 1

A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of
$1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $907.14. Calculate the promised yield on the bond.

A) 6.6%
B) 15.75%
C) 5.0%
D) None of the given values

Answer 1

15.75%

Question 2

If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $938.10. Calculate the promised yield on the bond. (assume no default)

A) 6.6%
B) 11.93%
C) 5.0%
D) None of the given values

Answer 2

11.93%

Question 3

The US government agrees to guarantee a bond issue planned by Demurrage Associates. The value of this guarantee:
I. Value of the loan with guarantee minus value of the loan without guarantee
II. Is a subsidy to equity investors in the firm issuing guaranteed debt
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 face value

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

Answer 3

I, II, and IV

Question 4

The interest rate on one-year risk-free bond is 5%. BAC company has issued a 5% 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) none of the above

Question 5

Which of the following bonds have the least risk?

A) AAA
B) AA
C) BAA
D) BA

Question 6

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

A) Corporate bond payments are made by a check from the firm and Treasury bonds are paid by printing money by the government.
B) Corporate bonds are traded on the floor of New York Bond Market and Treasury bonds trade in the over-the-counter market.
C) In the case of the corporate bond, the firm has the option to default whereas the government supposedly doesn't.
D) None of the above.

Question 7

The value of a bond that has a probability of default 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 8

A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of
$1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, calculate the expected payment from the bond.

A) $1,050
B) $400
C) $985
D) None of the above

Question 9

If a bond with one year maturity with a coupon rate of 5% and face value of $1,000 is selling for $881.94. Calculate the promised yield on the bond.

A) 5%
B) 8%
C) 19.06%
D) none of the above

Question 10

If the bond has 15% probability of default and payment under default is $400, calculate the expected payment from the bond.

A) $1,050
B) $400
C) $952.50
D) none of the above

Question 11

Federal government loan guarantees include the following:
I. housing
II. airlines
III. shipowners 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 12

If the discount rate on the bond is 8%, the expected payment in year-1 is $952.50; calculate the price of the bond:

A) $1050
B) $985
C) $907.14
D) none of the given answers

Question 13

Generally, you can insure corporate bonds through:

A) an arrangement with the Treasury department
B) an arrangement with the state government
C) credit default swap
D) none of the above

Question 14

If the discount rate on the bond is 7%, the expected payment in year-1 is $952.50; calculate the price of the bond:

A) $1050
B) $985
C) $890.19
D) none of the given answers

Question 15

Which of the following rated bonds have the least risk?

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

Question 16

The average yield spread based on promised yield on AAA bonds rated by moody's and the yield on Treasuries is about:

A) 1%
B) 2%
C) 5%
D) none of the above

Question 17

The value of a corporate bond can be thought of as:

A) Asset value - value of call on assets
B) Asset value + value of call on assets
C) Asset value + value of a default free bond
D) None of the above

Question 18

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) None of the above

Question 19

A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of
$1,000 at maturity. If the bond has 10% probability of default and payment under default is
$400, and an investor buys the bond for $890.19; Calculate the promised yield on the bond.

A) 6.6%
B) 17.95%
C) 7.0%
D) None of the given values

Question 20

If the discount rate on the bond is 5%, the expected payment in year-1 is $985; calculate the price of the bond:

A) $1050
B) $985
C) $938.10
D) none of the given answers

Question 21

Beaver, McNichols and Rhie have developed the following model to predict the chance of failing during the next year relative to 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 analysis
B) real options analysis
C) hazard analysis
D) none of the above

Question 22

The value of a risky bond is equal to: value of a bond without default - value of a put option on assets.

Question 23

Banks concerned about risk of loss, may measure Value-at-Risk over what time period?

A) 1 day
B) 1 week
C) 1 month
D) all of the above

Question 24

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

Question 25

The default rate on BBB rated bonds ten years after the issue is:

A) 0.3%
B) 3.1%
C) 6.6%
D) 24.0%

Question 26

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

Question 27

Between 1981-2008, the percentage of bonds that were rated AAA remained AAA was
(Approximately):

A) 88.39%
B) 87.06%
C) 87.22%
D) None of the above

Question 28

Given the following data: ROA = 10%; total liabilities = 90% of the 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) 1.7%
B) 1.09%
C) 0.16%
D) none of the above

Question 29

Generally, a corporate bond has a higher expected yield than a government bond.

Question 30

In 2001, what percentage of junk bond issues defaulted?

A) 6.2%
B) 11.0%
C) 15.6%
D) 24.0%

Question 31

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

A) 12.4%
B) 28.3%
C) 37.5%
D) 42.5%

Question 32

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

Question 33

The median TIE (EBIT/interest) ratio for industrial firms with AAA bond ratings is:

A) 23.8
B) 19.5
C) 8.0
D) 4.7

Question 34

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

Question 35

The value of a risky bond is equal to: asset value - value of call option on assets.

Question 36

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

A) $2.1 mil
B) $7.0 mil
C) $28.5 mil
D) $30 mil

Question 37

Bonds rated below BBB (Baa) are called:

A) Investment grade bonds
B) Junk bonds
C) Default-free bonds
D) None of the above

Question 38

Z-score model was developed by Altman using:

A) multiple discriminant analysis
B) real options analysis
C) hazard analysis
D) none of the above

Question 39

Bonds rated below BBB (Baa) are termed "Junk bonds."

Question 40

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 41

What is credit default swap? Briefly explain.

Question 42

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

Question 43

Briefly explain how the Option pricing model can be used for pricing risky debt?

Question 44

Briefly explain bond ratings.

Question 45

Briefly explain the term junk bonds.

Question 46

Define the term "credit risk."

Question 47

Briefly explain the term "credit scoring."

Question 48

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

Question 49

A value at risk calculation requires some level of statistical confidence level expressed by the firm.

Question 50

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

Question 51

What is a major drawback to value at risk calculations?

Question 52

The value at risk of a bank can change with the risk tolerance of the bank.