LOS j: Describe the various forms of credit risk and describe the meaning and role of credit ratings.

Q1. Which of the following statements is TRUE?

A)   Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

B)   Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.

C)   When a rating agency downgrades a security, the bond's price usually falls.

Q2. Credit risk is measured in several ways. The yield differential above the return on a benchmark security measures the:

A)   credit spread risk.

B)   default risk.

C)   recovery rate.

Q3. When planning to hold a coupon-paying Treasury bond until maturity, which of the following types of risk would be the most important?

A)   Reinvestment.

B)   Default.

C)   Interest rate.

Q4. With respect to bond investing, reinvestment risk is a very important component of what other type of risk?

A)   Liquidity risk.

B)   Default risk.

C)   Call risk.

Q5. Which of the following will most likely have the least impact on a corporate bond rating? The:

A)   issuing company's volume of sales.

B)   issue's indenture provisions.

C)   issuing company's debt burden.

Q6. Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?

A)   97.76.

B)   98.19.

C)   101.35.

Q7. Benjamin Zoeller and Tara McGonigal are preparing for the Level I CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50% and a risk premium of 3.00%. What does Zoeller tell her to use for the default free rate?

A)   6.50%.

B)   9.50%.

C)   12.50%.

Q8. When determining credit risk spread, the benchmark security is most likely a(n):

A)   AA rated bond.

B)   high-yield corporate bond.

C)   Treasury bond.

LOS j: Describe the various forms of credit risk and describe the meaning and role of credit ratings.fficeffice" />

Q1. Which of the following statements is TRUE?

A)   Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

B)   Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.

C)   When a rating agency downgrades a security, the bond's price usually falls.

Correct answer is C)

The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price will likely fall. Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation. The percentage recovered is known as the recovery rate.

Q2. Credit risk is measured in several ways. The yield differential above the return on a benchmark security measures the:

A)   credit spread risk.

B)   default risk.

C)   recovery rate.

Correct answer is A)

The yield differential above the return on a benchmark security measures the credit spread risk. Credit spread risk is also known as the risk premium or spread.

Q3. When planning to hold a coupon-paying Treasury bond until maturity, which of the following types of risk would be the most important?

A)   Reinvestment.

B)   Default.

C)   Interest rate.

Correct answer is A)

Since it is a Treasury bond, default risk is not relevant. Interest rate risk is not important because the investor plans to hold the bond until maturity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she will be able to reinvest the coupons over the life of the bond and the principal upon maturity.

Q4. With respect to bond investing, reinvestment risk is a very important component of what other type of risk?

A)   Liquidity risk.

B)   Default risk.

C)   Call risk.

Correct answer is C)

Call risk is composed of three components: the unpredictability of the cash flows, the compression of the bond’s price, and the high probability that when the bond is called the investor will be faced with less attractive investment opportunities. This latter risk is reinvestment risk. Reinvestment risk is not a directly related to any of the other choices.

Q5. Which of the following will most likely have the least impact on a corporate bond rating? The:

A)   issuing company's volume of sales.

B)   issue's indenture provisions.

C)   issuing company's debt burden.

Correct answer is A)

The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm. However, the other choices, leverage and indenture provisions, are more directly related to the bond’s rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall.

Q6. Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?

A)   97.76.

B)   98.19.

C)   101.35.

Correct answer is A)

Since the corporate bond involves credit risk and the government bond doesn't. The corporate bond price has to be less than the government bond price which is computed as follows:

Government Bond Price = 6 / 1.07 + 106 / 1.07² = 98.19

Q7. Benjamin Zoeller and Tara McGonigal are preparing for the Level I CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50% and a risk premium of 3.00%. What does Zoeller tell her to use for the default free rate?

A)   6.50%.

B)   9.50%.

C)   12.50%.

Correct answer is A)

The formula for credit spread risk (or the yield on a risky asset) is:

         Yield_Risky = Yield_RF + Risk Premium, where RF = default ? free rate.

Rearranging this formula results in: Yield_RF = Yield_Risky – Risk Premium, or Yield_RF = 9.50% – 3.00% = 6.50%.

Q8. When determining credit risk spread, the benchmark security is most likely a(n):

A)   AA rated bond.

B)   high-yield corporate bond.

C)   Treasury bond.

Correct answer is C)        

The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The AA rated bond is high quality, but not the highest quality (which would have an AAA rating). The high-yield corporate bond is an unlikely candidate for the benchmark security because high yield usually denotes high risk.

credit rate

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