Question 1

The default risk premium is measured

Accepted Answer

The default risk premium is generally calculated 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 to be risk-free, and any excess yield on a non-Treasury security reflects the additional risk involved in investing in that security. Option A is incorrect because the SEC does not publish an index for default risk premium. Option B is incorrect because The Wall Street Journal does not publish an index for default risk premium. Option D is incorrect because it refers to a different concept (the real after-tax yield), which is not related to default risk premium.

Question 2

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, it must offer investors higher yields to compensate them for the risk they take in buying their bonds or making loans. This is because investors will demand a higher return to take on the increased risk of default.

Question 3

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

Accepted Answer

Moody's refers to bonds rated Baa and higher as "investment grade," while bonds rated Ba and below are considered "speculative grade" or "junk bonds." Therefore, Baa would not be considered below investment grade.

Question 4

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. While their prices may fluctuate based on market conditions, they are still considered a low-risk investment. Option A is incorrect as Treasury prices can and do change. Option B is also incorrect as there have been no historical instances of default on U.S. Treasury securities. Option D is incorrect as there is typically a very small default risk premium associated with U.S. Treasury securities.

Question 5

Default risk

Accepted Answer

Default risk refers to the likelihood that a borrower will not fully repay the principal or interest on a loan. This risk is present in all types of borrowers, including large corporations, small businesses, and municipalities. It is a key consideration for investors when assessing the creditworthiness of a bond issuer.

Question 6

The default risk premium is

Accepted Answer

The default risk premium is the additional yield that an investor demands for holding a bond with some risk of default. It is relevant for any security that carries some risk of default, regardless of the size of the issuing company. It is not necessarily zero for corporate bonds, and it can vary across the business cycle. It is not relevant for corporate stock, as stocks do not have a guaranteed return and are not subject to default risk in the same way as bonds.

Question 7

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 US government, which is considered to have a very low probability of default. The other options involve securities issued by private corporations, which carry some level of default risk.

Question 8

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 investors often pay professional analysts to gather and monitor such information to mitigate their risk and make informed investment decisions. This is particularly important for investors who are risk-averse or who want to maximize their returns by minimizing default risk. Federal law does not require investors to pay professional analysts, and while some investors may be risk-neutral, most are not. While analyzing a borrower's creditworthiness may increase yield, this is not the primary reason why investors pay professional analysts for this information.

Question 9

The default risk premium fluctuates mainly

Accepted Answer

The default risk premium is the difference between the yield on a risky bond and the yield on a risk-free bond. It fluctuates as new information about a borrower's creditworthiness becomes available, such as changes in their financial position, industry trends, or economic conditions. As this information changes, investors may reassess the riskiness of the borrower and adjust the premium accordingly. The other answer options do not accurately explain why the default risk premium fluctuates.

Question 10

Which of the following assigns widely-followed bond ratings?

Accepted Answer

Standard & Poor's Corporation is a global provider of credit ratings, financial analysis, and risk solutions. They are widely followed for their bond ratings. The Securities and Exchange Commission oversees the markets and requires disclosure of certain information, but they do not assign bond ratings. The Federal Reserve is responsible for monetary policy and bank regulation, but they do not assign bond ratings. IBM is a technology company and has no involvement in assigning bond ratings.

Question 11

Default risk arises from the fact that

Accepted Answer

Default risk refers to the risk that a borrower will default on a loan and be unable to repay the agreed-upon principal and interest. This risk arises because borrowers differ in their ability to repay their debts, and some borrowers are more likely to default than others. Similarly, lenders can reduce their exposure to default risk by charging higher interest rates or requiring collateral or other forms of security to protect their loans.

Question 12

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 13

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 14

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 premium (higher yield) for taking on the risk of a risky security. This means that the yield on a risky security will be greater than that on a safe security. Additionally, the price of a risky security should be lower than that of a safe security since investors will be less willing to pay as much for a risky security given the higher risk level. Therefore, the correct choice is C.

Question 15

Bond ratings

Accepted Answer

Bond ratings are typically published by private bond-rating agencies such as Standard & Poor's, Moody's, and Fitch. These agencies evaluate the creditworthiness of issuers and assign ratings based on a variety of factors such as financial performance, market conditions, and risk. The ratings are important for investors as they provide an indication of the risk associated with a particular bond or issuer.

Question 16

The risk premium of corporate bonds typically increases

Accepted Answer

During a recession, there is typically a higher risk of default on corporate bonds due to a decline in the company's profitability and ability to repay its debts. This risk is reflected in the higher risk premium demanded by investors when purchasing corporate bonds. Therefore, the risk premium of corporate bonds typically increases during a recession.

Question 17

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

Accepted Answer

Owning junk bonds can be profitable if market perceptions of their risk decline, as the price of the bonds would increase. Junk bonds can be high-risk and do not always perform well, but they can still offer opportunities for profit.

Question 18

The risk structure of interest rates refers to

Accepted Answer

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

Question 19

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 answer of Currently, a three-month Treasury bill has a...

Question 20

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.

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