Week 9

Question 1

What three risk factors that are attributes of bonds and affect its interest rate?

Answer 1

1) Default Risk
2) Liquidity
3) Income Tax Considerations

Question 2

What is default risk?

Answer 2

• One attribute of a bond that influences its interest rate is its
  risk of default, which occurs when the issuer of the bond is
  unable or unwilling to make interest payments when promised.
• A corporation suffering big losses, such as the major airline
  might be more likely to suspend interest payments on its
  bonds. The default risk on its bonds would therefore be quite
  high.

Question 3

What is default-free bonds?

Answer 3

-U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always
increase taxes to pay off its obligations (or just print money). Bonds like these with no default risk are called default-free bonds.

Question 4

What is risk premium?

Answer 4

• The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium,
  indicates how much additional interest people must earn in
  order to be willing to hold that risky bond.

Question 5

Is a bond with default risk always positive?

Answer 5

-A bond with default risk will always have a positive risk
premium, and an increase in its default risk will raise the risk
premium.
- And this can be explained by the bond supply and demand

Question 6

How does default risk link with risk premium?

Answer 6

• Default risk is an important component of the size of the risk premium.
• Because of this, bond investors would like to know as much as
  possible about the default probability of a bond.

Question 7

What are investment grade securities?

Answer 7

• Bonds with relatively low risk of default are called investment-grade securities and have a rating of Baa (or BBB) and above
• Bonds with ratings below Baa (or BBB) have higher default
  risk and have been aptly dubbed speculative grade or junk bonds

Question 8

How is liquidity an attribute of a bond and how does it influence its interest rate?

Answer 8

• a liquid asset is one that can be quickly and cheaply converted into cash if the need arises.
• The more liquid an asset is, the more desirable it is (higher
  demand), holding everything else constant.
• Treasury bonds are the most liquid of all long-term bonds;
  because they are so widely traded, they are the easiest to sell quickly and the cost of selling them is low.
• Corporate bonds are not as liquid because fewer bonds for anyone corporation are traded; thus, it can be costly to sell these bonds in an emergency because it might be hard to find
  buyers quickly.

Question 9

What is the difference between interest rates on corporate bonds and treasury bond?

Answer 9

-The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but its liquidity too. This is why a risk premium is sometimes called a risk and liquidity premium

Question 10

What are municipal bonds?

Answer 10

are debt securities issued by local governments (such as cities, counties, or states) or their agencies to raise funds for public projects. These projects could include infrastructure development, like building schools, bridges, or roads, or funding other essential services.

Question 11

What is the reason for municipal bonds?

Answer 11

-The main reason for municipal bonds’ lower interest rate than
the Treasury bonds is that municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.