Question 1

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, and many investors may not have the time or expertise to perform this analysis themselves. Therefore, they may pay professional analysts to gather and monitor this information on their behalf.

Question 2

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

Accepted Answer

The highest bond rating assigned by Moody's Investors Service is Aaa. A rating of Aaa indicates that the issuer has a high creditworthiness and is highly unlikely to default on its debt obligations.

Question 3

Default risk arises from the fact that

Accepted Answer

Default risk arises because borrowers have different abilities to repay the principal and interest required by a bond agreement. This risk is associated with the potential for the borrower to default on their loan obligations, resulting in a loss for the lender. Default risk is higher for borrowers with weaker credit profiles, lower financial strength, or less collateral.

Question 4

The risk premium of corporate bonds typically increases

Accepted Answer

The risk premium of corporate bonds typically increases during a recession, as investors become more risk averse and demand higher compensation for the risk of default.

Question 5

Bond ratings

Accepted Answer

Bond ratings are typically published by private bond-rating agencies such as Standard and Poor's, Moody's, and Fitch. These agencies analyze the creditworthiness of a bond issuer and assign a rating based on factors such as financial stability, payment history, and market trends. The ratings are then made available to investors and others in the financial industry to inform their buying and selling decisions.

Question 6

The default risk premium fluctuates mainly

Accepted Answer

The default risk premium represents the additional return investors require to compensate for the risk of a borrower defaulting on their debt obligations. As new information about a borrower's creditworthiness becomes available, investors may adjust their perception of default risk, causing fluctuations in the default risk premium. Choice A is incorrect because bond rating agencies generally play a key role in assigning credit ratings that help determine default risk. Choice B is incorrect because risk-neutral investors do not have a preference for risk and will not become risk-averse over time without a change in circumstances. Choice C is incorrect because taxes do not necessarily have a direct impact on default risk or the default risk premium.

Question 7

Which of the following is the lowest rating given to an investment-grade bond by Moody's?

Accepted Answer

Baa is the lowest rating given to an investment-grade bond by Moody's. Ratings above Baa are considered investment grade, while those below are considered speculative or non-investment grade.

Question 8

U)S.Treasury securities

Accepted Answer

U.S. Treasury securities are considered default-risk-free instruments because they are backed by the U.S. government and are considered to have a very low risk of default. However, their prices can still change due to fluctuations in interest rates and market conditions.

Question 9

Default risk

Accepted Answer

Default risk refers to the risk that a borrower, whether a corporation or a government, will default on paying the promised coupon or principal amount. It is not limited to small corporations and is different from market risk. Therefore, option B and C are incorrect. Option D is also incorrect as even bonds issued by cities and states carry a certain level of default risk.

Question 10

The default risk premium is measured

Accepted Answer

The default risk premium is measured as the difference between the yield on a non-Treasury security and the yield on a U.S. Treasury security of the same maturity. This is because U.S. Treasury securities are considered risk-free, so the difference in yield between a non-Treasury security and a Treasury security of the same maturity reflects the additional risk investors must take on to invest in the non-Treasury security. The Securities and Exchange Commission and The Wall Street Journal do not publish indices related to default risk premium, and the calculation does not involve after-tax yields.

Question 11

Currently,a three-month Treasury bill has a yield of 5% while the yield on a ten-year Treasury bond is 4.7%.What is the risk premium of the typical A-rated ten-year corporate bond with a yield of 5.5%?

Accepted Answer

The risk premium of the A-rated ten-year corporate bond is calculated by subtracting the yield of the ten-year Treasury bond (which is considered risk-free) from the yield of the corporate bond. Therefore, 5.5% (corporate bond yield) - 4.7% (ten-year Treasury bond yield) = 0.8%.

Question 12

The risk structure of interest rates refers to

Accepted Answer

The answer of The risk structure of interest rates refers...

Question 13

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

Accepted Answer

A three-month Treasury bill is considered a default-risk-free instrument because it is backed by the full faith and credit of the US government. Commercial paper, shares of stock, and corporate bonds are all subject to default risk.

Question 14

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

Accepted Answer

When a company's ability to repay its obligations in full is uncertain, investors are more likely to demand higher yields for the risk they take in buying their bonds or making loans. This is because the higher the risk of default, the higher the compensation investors will require to compensate them for that risk.

Question 15

Which of the following assigns widely-followed bond ratings?

Accepted Answer

Standard & Poor's Corporation assigns widely-followed bond ratings. The Securities and Exchange Commission regulates securities markets, the Federal Reserve controls monetary policy, and IBM is a technology company.

Question 16

Which of the following statements about junk (high-risk)bonds is TRUE?

Accepted Answer

Junk bonds are high-risk, high-yield bonds issued by companies with poor credit ratings. As a result, they typically offer higher yields than other types of bonds. Their value can fluctuate widely depending on market perceptions of the issuer's creditworthiness. If market perceptions improve and the issuer's creditworthiness is considered less risky, the price of the bond will increase, and the owner will profit. Therefore, option D is true. Option A is incorrect because junk bonds may outperform treasury bonds during certain periods. Option B is incorrect because the price of junk bonds decreases as their perceived risk increases. Option C is incorrect because junk bonds tend to perform poorly during recessions.

Question 17

If lenders anticipate no changes in liquidity,information costs,and tax differences,the yield on a risky security should be

Accepted Answer

If lenders anticipate no changes in liquidity, information costs, and tax differences, they will demand a higher yield for a risky security to compensate for the additional risk. As a result, the yield on a risky security should be greater than that on a safe security. Moreover, since the price of a security and its yield are inversely related, the price of a risky security should be lower than that of a safe security, making option C the correct answer.

Question 18

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 compare the after-tax yield of a taxable bond to a tax-free municipal bond, we use the following formula:

Taxable equivalent yield = Tax-free yield / (1 - Tax rate)

Plugging in the numbers given in the question, we get:

Taxable equivalent yield = x / 0.8

We want to find the minimum tax-free yield that would make it more beneficial than the 3-year Treasury note paying 4.75%. So we set up the following inequality:

x / 0.8 > 4.75

x > 3.8

Therefore, the minimum interest rate that you would need to earn on a tax-free municipal bond in order to buy it instead is 3.8%, which is choice B.

Question 19

Which of the following bond ratings by Moody's Investors Service would NOT be considered to be below investment grade?

Accepted Answer

Only ratings below Baa are considered below investment grade. Baa is considered medium grade, while Ba and B are considered speculative.

Question 20

The default risk premium is

Accepted Answer

The default risk premium is the additional yield that investors demand for holding a bond with some default risk. It is relevant for any issuer with default risk, not just small companies, and it is not necessarily zero for corporate bonds or constant across the business cycle.

Quiz 5: The Risk Structure and Term Structure of Interest Rates