5. Interest rate spread Suppose that a 5-year Treasury bond pays an annual rate

Question

5. Interest rate spread

Suppose that a 5-year Treasury bond pays an annual rate of return of 4.3%, and a 5-year bond of the fictional company Risky Investment Inc. pays an annual rate of return of 7.5%. The risk premium on the Risky Investment bond is (3.2/ 4.3/ 7.5/ 5.6) percentage points. Consider an increase in the annual rate of return on the Risky Investment bond from 7.5 percent to 9.9 percent. Such a change would (narrow/widen) the interest rate spread on the Risky Investment bond over Treasuries to (5.6/ 7.5/ 4.3/ 3.2/) .

Which of the following explains the increase in the annual rate of return on the Risky Investment bond?

A. The expected default rate on the Risky Investment bond has increased.

B.The expected default rate on the Risky Investment bond has decreased.

C.The expected default rate on the Treasury bond has increased.

D.The expected default rate on the Treasury bond has decreased.

Explanation / Answer

Risk Premium of a Risky Investment is the difference between Risk-free return and the rate of return associated with Risky Investment.

So The Risk - Premium on the Risky Investment Bond = (7.5 - 4.3) = 3.2

The result of an increase in the annual rate of return on the Risky Investment bond from 7.5 percent to 9.9 percent will lead to widen the interest rate spread on the Risky Investment bond over Treasuries to 5.6.

A. The expected default rate on the risky Investment bond has increased.

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.