Question 1

Default risk

Accepted Answer

Default risk refers to the likelihood that a borrower will not repay the full amount of principal and interest as promised. It applies to all types of bonds, not just those issued by small corporations. It is also distinct from market risk, which refers to the possibility of losing money due to changes in market conditions. While bonds issued by cities and states may have lower default risk than those from private companies, they are not immune to default risk altogether.

Question 2

Currently, a three-month Treasury bill pays 5% interest and a ten-year Treasury bond pays 4.7% interest. What is the risk premium of the typical A-rated corporate bond that pays 5.5% interest?

Accepted Answer

The risk premium is the additional return that investors demand for taking on the risk of investing in a corporate bond rather than a risk-free investment, such as a Treasury bill or bond. The difference between the interest rate on the A-rated corporate bond (5.5%) and the ten-year Treasury bond (4.7%) is the risk premium, which is therefore 0.8%.

Question 3

Which of the following is the highest bond rating assigned by Moody's Investors Service?

Accepted Answer

Aaa is the highest bond rating assigned by Moody's Investors Service.

Question 4

Default risk arises from the fact that

Accepted Answer

Default risk arises from the fact that borrowers differ in their ability to repay in full the principal and interest required by a loan agreement. Some borrowers may have difficulty making their payments, leading to default or delay in payments. This risk is inherent in all types of lending activities and is the primary reason why lenders charge interest rates and impose other terms and conditions on loans to manage this risk.

Question 5

Bond ratings

Accepted Answer

Bond ratings are typically published by private bond-rating agencies such as Moody's, Standard & Poor's, and Fitch Ratings. These agencies evaluate the creditworthiness of bond issuers and assign ratings based on factors such as financial performance, debt levels, and industry trends. The ratings are meant to provide investors with an assessment of the risk associated with purchasing a particular bond.

Question 6

Currently, a three-year Treasury note pays 4.75%. Assuming that your tax rate is 20%, what is the minimum interest rate that you would you need to earn on a tax-free municipal bond in order to buy it instead?

Accepted Answer

To find the minimum interest rate needed on the tax-free municipal bond, we need to calculate the taxable equivalent yield (TEY) of the municipal bond. 
TEY = tax-free yield / (1 - tax rate)
TEY = x / (1 - 0.20) 
TEY = x / 0.80

We want to find x, so we can solve for x:
x / 0.80 = 4.75
x = 4.75 * 0.80
x = 3.8

Therefore, the minimum interest rate needed on the tax-free municipal bond is 3.8%, which is option B.

Question 7

U.S. Treasury securities

Accepted Answer

U.S. Treasury securities are considered default-risk-free instruments because they are backed by the full faith and credit of the U.S. government, meaning there is virtually no chance of default. However, their prices do change based on market conditions, so option A is incorrect. While there have been instances of U.S. default in history, they have not been related to Treasury securities, so option B is incorrect. The default risk premium for U.S. Treasury securities is generally lower than for other investments due to their perceived safety, so option D is also incorrect.

Question 8

The risk structure of interest rates refers to

Accepted Answer

The risk structure of interest rates refers to the relationship among the interest rates on bonds with the same maturity but different risk characteristics, such as default risk or liquidity.

Question 9

The default risk premium is

Accepted Answer

The default risk premium is the additional yield that investors demand to hold a risky instrument like a corporate bond, reflecting the likelihood of default on the part of the borrower. It is relevant for any instrument with default risk, and not just for securities issued by small companies. Its magnitude can vary depending on the creditworthiness of the borrower and prevailing economic conditions, and is not constant across the business cycle. For example, in times of economic expansion and lower unemployment, default risk may be perceived to be lower and the default risk premium may be correspondingly lower.

Question 10

Which of the following assigns widely-followed bond ratings?

Accepted Answer

Standard & Poor's Corporation is a leading credit rating agency that assigns widely-followed bond ratings. The Securities and Exchange Commission oversees financial markets and securities offerings but does not assign bond ratings. The Federal Reserve is responsible for monetary policy but does not assign bond ratings. IBM is a business corporation and is not involved in assigning bond ratings.

Question 11

Which of the following is considered a default-risk-free instrument?

Accepted Answer

Treasury bills are considered default-risk-free because they are issued by the government, which is generally perceived as having a very low risk of default. The other options involve corporate issuers which may carry some level of credit risk or default risk.

Question 12

When a company whose ability to repay its obligations in full is uncertain borrows funds

Accepted Answer

A company with an uncertain ability to repay its obligations would have to offer higher yields to attract investors to buy their bonds or make loans. This is because the investors would be taking on a greater risk by lending money to a company with a higher probability of default. The company may be forced to issue debt with longer maturities as well, although this is not always the case. The price of the bonds would generally be lower, not higher, due to the increased risk. The company could choose to borrow funds through financial intermediaries or through financial markets, depending on the circumstances.

Question 13

Savers who are risk-averse

Accepted Answer

Savers who are risk-averse care about both expected returns and the variability of returns. They want to choose an investment that offers both a reasonable expected return and low variability in returns, so that they can minimize the possibility of losing money. They are willing to accept lower expected returns if it means they can reduce the risk of losses.

Question 14

Because savers are generally risk-averse

Accepted Answer

Yields on investments like corporate bonds often include a premium for bearing default risk, reflecting the risk-averse nature of savers who demand higher returns for taking on additional risks.

Question 15

The default risk premium is measured

Accepted Answer

The default risk premium is the additional return an investor expects to earn for investing in a security that is subject to default risk. This is typically measured as the difference between the yield on the security and the yield on a U.S. Treasury security of the same maturity. This is because U.S. Treasury securities are considered to be free of default risk, and therefore their yield is considered to be the risk-free rate. The default risk premium can vary depending on the creditworthiness of the issuer and the overall economic environment.

Question 16

If the average risk premium of corporate bonds increases,

Accepted Answer

An increase in the average risk premium of corporate bonds often indicates that investors are demanding higher returns for taking on additional risk, which can be a sign of growing concerns about the economy or specific sectors, potentially signaling a looming recession.

Question 17

Investors often pay professional analysts to gather and monitor information on the creditworthiness of borrowers because

Accepted Answer

The cost of acquiring information about a borrower's creditworthiness can be high, so investors often pay professional analysts to gather and monitor this information. This helps them make informed decisions about which borrowers are likely to repay their debts, thereby reducing the risk of default and increasing the potential return on investment.

Question 18

Savers generally are

Accepted Answer

Savers are generally risk-averse, meaning that they prefer to avoid risk even if it means potentially lower returns. This is because they want to protect the value of their savings and ensure that they have enough to meet their future financial needs.

Question 19

Risk-neutral savers care

Accepted Answer

Risk-neutral savers are indifferent to the risk (variability of returns) and make decisions based solely on the expected returns of their investments.

Question 20

The default risk premium

Accepted Answer

The default risk premium is the additional yield that a risky security must offer over a default-free security to compensate investors for the risk of default. This additional yield brings the expected yield on a security into equality with the expected yield on a default-free security.

Quiz 7: Risk Structure and Term Structure of Interest Rates