Question

1. Suppose the market value of risky and risk free bonds is initially $850 with a corresponding return of 17.6 %, illustratively discuss the probable reaction of bond buyers and sellers when corporate bonds become riskier to such an extent that the market value of corporate bonds falls to $800 with a corresponding 25% rate of return. If the response of buyers causes the price of risk-free bonds to rise to$900 with a corresponding 11.1 % rate of return, derive the risk premium.

Answer 1

Initially it seems very odd to have values or yield of risky and risk free bonds to be equal but there do exist some cases in which only a few of corporates of any economy may demand a rating or yield equivalent to the underlying economy itself.

However if the situation exist and if the corporate bonds becomes riskier the initial reaction definitely will be selling of risky bonds and rush towards the risk free bonds which will naturally push the yields higher and prices lower.

The primary reason for the spreads to be virtually zero initially can be because the economy was in a boom and probably as the economy enters into a slow growth or recession mode the corporates bonds looks less promising in fulfilling the interest payments, hence the selling and hence the price tumbles and yields rise.

Also the new sellers will have to issue bonds at the discount which in result will offer higher yield to the investors. And then investors as per their risk appetite will invest in risky or risk free bonds.

The risk premium is basically the return earned in excess of the risk free rate. It is normally a form of compensation for the investors to tolerate the extra risk which they take.

Hence Risk Premium = Yield of Risky Bond - Yield of Risk Free bond = 25% - 11.1% = 14.1%