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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’s 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

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’s predictions for the inflation rate in the future?

Go to the St. Louis Federal Reserve FRED database, and find daily yield data on the following U.S. treasuries securities: one-month (DGS1MO), three-month (DGS3MO), six-month (DGS6MO), one-year (DGS1), two-year (DGS2), three-year (DGS3), five-year (DGS5), seven-year (DGS7), 10-year (DGS10), 20-year (DGS20), and 30-year (DGS30). Download the last full year of data available into a spreadsheet.

a. Construct a yield curve by creating a line graph for the most recent day of data available, and for the same day (or as close to the same day as possible) one year prior, across all the maturities. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

b. Determine the date of the most recent Federal Open Market Committee policy statement. Construct yield curves for both the day before the policy statement was released and the day on which the policy statement was released. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?

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

The table below shows current and expected future one-year interest rates, as well as current interest rates on multi-year bonds. Use the table to calculate the liquidity premium for each multiyear bond.

If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds, and (b) the segmented markets theory of the term structure holds.
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