Question 1

Briefly describe bond ratings.

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Question 2

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

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Question 3

Briefly explain the term junk bonds.

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Question 4

Define the term credit risk.

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Question 5

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

Accepted Answer

Bonds rated BBB (Baa) and above are actually considered investment-grade bonds, not junk bonds. Junk bonds are typically rated below BB (Ba) and are viewed as having a higher risk of default.

Question 6

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

Accepted Answer

Investment-grade bonds are typically considered safe and reliable investments, and as such, they can usually be entered at face value on the books of banks and life insurance companies. This means that their full value is recognized and recorded by these institutions, providing a level of security for bondholders.

Question 7

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

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Question 8

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.

Accepted Answer

If a bond's default risk is unrelated to the economy, it implies no systematic risk, resulting in a beta of zero. Consequently, the bond's discount rate would be the risk-free rate, as it only compensates for time value of money, not risk.

Question 9

What is a credit default swap? Briefly explain.

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Question 10

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

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Question 11

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

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Question 12

Briefly explain the term credit scoring.

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Question 13

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

Accepted Answer

The longer the maturity of a bond, the more time the firm has to potentially default on the bond, which increases the value of the firm's right to default. This is because bondholders are more likely to accept a lower payment in the present if they believe there is a higher risk of default in the future.

Quiz 23: Credit Risk and the Value of Corporate Debt