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Chapter 6: Q.2 (page 187)

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody鈥檚 Baa rating or a corporate bond with a C rating? Why?

Short Answer

Expert verified

A bond is a financial instrument that a company releases to raise funds and then pays interest to the investors. The bond's interest rate can be fixed or variable.

Step by step solution

01

To determine

The larger the risk premium on a corporate bond's interest rate, the higher the rating.

02

Explanation

In comparison to a corporate bond with a Baa rating, a corporate bond with a rating will have a higher risk premium on its interest. When compared to corporate bonds with a Baa rating, the C grade bond has a higher default risk, which reduces demand and raises interest rates.

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Most popular questions from this chapter

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%,6%and 6%respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A and B?

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market鈥檚 predictions for the inflation rate in the future?

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curves for the following paths of one-year interest rates over the next four years:

a. 4%, 6%, 11%, 15%

b. 3%, 5%, 13%, 15%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curves for the following paths of one-year interest rates over the next four years:

a. 5%;7%;12%;12%

b.7%;5%;3%;5%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?
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