EC223 Lecture Notes - Lecture 2: Credit Risk, Risk Premium

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amethystpanda585

19 Sep 2018

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Risk structure of interest rates relationship among the interest rates on various bonds with the same term to maturity. Term structure of interest rates relationship among interest rates on bonds with different terms to maturity. Risk of default risk of the issuer of the bond being unable or unwilling to make interest payments wen promised or to pay off the face value when the bond matures. Default free bonds government backed, risk free bonds (ex. Risk premium spread between the interest rate on bonds with default risk and te interest rate on default free bonds. A bond with a default risk will always have a positive risk premium and an increase in its default risk will raise the risk premium. Credit rating agencies investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. Junk bonds bonds with ratings below bbb and have higher default risks.

Related Questions

11.1 The four fundamental factors that affect the supply and demand for investment capital that affect interest rates are investment opportunities, time preferences for consumption, risk, and inflation. Explain how each of these factors affects the cost of money.

11.2 The interest rate required by investors on a debt security can be expressed by the following equation:

Interest rate = RRF + IP + DRP + LP + MRP + CRP. Define each term of the equation, and explain how it affects the interest rate.

11.3 Briefly describe the following types of debt: a. Term loan b. Bond c. Mortgage bond d. Senior debt; junior debt, e. Debenture f. Municipal bond

11.4 Indenture Restrictive covenant Trustee Call provision (1) (2) (3) (4). What are the three primary bond rating agencies? What do bond ratings measure? How do investors interpret bond ratings? What is the difference between an A-rated bond and a B-rated bond? Why are bond ratings important to investors? Why are ratings important to businesses that issue bonds?

11.5 What is interest rate risk? What is price risk? What is a reinvestment rate risk?

11.6 Is this statement true or false? The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Explain your answer.

viridiansardine578

The United States territory of Puerto Rico was effectively downgraded to non-investment grade on February 4, 2014 by Standard & Poorâs when it downgraded Puerto Ricoâs general obligation debt from BBB- status to BB+, on level below investment grade. Moodyâs and Fitch Ratings quickly followed and within a matter of 10 days all three ratings agencies had downgraded Puerto Ricoâs debt.

Each of these downgrades triggered several covenants, or acceleration clauses, which forced Puerto Rico to repay certain debt instruments within months rather than years. Also resulting from the downgrades was an increase in Puerto Ricoâs cost of capital. Unlike a corporation, municipalities such as cities, states, and territories are 100% debt financed. Thus, a drop in credit rating to junk bond status requires Puerto Rico to offer investors a higher rate of interest on new debt issues and will reduce the market value of existing bonds. Therefore, improving the situation by restructuring existing bonds and issuing new bonds becomes an extremely difficult task. While municipal financing differs from corporate financing, the prescription for lowering the cost of borrowing is similar for both: increase revenues and/or cut costs. Puerto Rico currently states that it is unable to maintain its current operations unless it takes drastic measures that may lead to civil unrest. This includes cutting payments to government pensioners and slashing health care funding. There have already been protests over the austerity measures.

The devastation caused by Hurricane Irma (and now potentially Hurricane Maria) is likely to worsen the situation as previously allocated municipal funds will need to be diverted for the relief effort. If you were tasked with proposing a solution to the situation, which must address the rising cost of capital, how would you approach the issue?

EC223 Lecture Notes - Lecture 2: Credit Risk, Risk Premium

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