Question

Analysts consider the bonds issued by the Great Western Railroad as having greater risk of default than bonds issued by Kraft Foods. The term to maturity of the bonds is the same, and there is a ready market for buying and selling each bond. Which of the following statements is true?

A. The required return on the Great Western bonds is less than the required return on the Kraft Foods bonds.
B. The required return is the same for the Great Western bonds as they are for the Kraft Foods bonds.
C. The required return on the Great Western bonds is greater than the required return on the Kraft Foods bonds.
D. More information is needed to answer this question. Which of the following bonds has a lowest required rate of return? A. A one-year treasury bill. B. A five year treasury bill. C. A ten-year treasury bill. D. It is impossible to tell which will have a lower required return because they are all treasury bills. The liquidity risk premium is based upon which of the following factors? A. The likelihood that the borrower will not pay interest and/or principle values owed to lenders. B. The ease with which it is possible to buy and/or sell the security (e.g., bond) in question. C. The term to maturity of the security. D. All of the above are sources of liquidity risk. The number of lenders in the funds market decreases as several major banks cease doing business. Which of the following would most likely result in the market for funds? A. Supply would decrease, leading to a surplus of funds, and a lower market clearing interest rate. B. Supply would decrease, leading to a shortage of funds and a higher market clearing interest rate. C. Supply would increase, leading to a surplus of funds and a lower market clearing interest rate. D. Supply would increase, leading to a shortage of funds and a higher market clearing interest rate.

Answer 1

1. C. The required return on the Great Western bonds is greater than the required return on the Kraft Foods bonds.

Required rate of return on bonds include a risk factor for possibility of default. Hence the rate on the Great western bonds will be higher.

2. A. A one-year treasury bill.

(Since the maturity period is lower on a a 1 year treasury bill, it carries a lower risk. Hence its return will be lower)

3. B. The ease with which it is possible to buy and/or sell the security (e.g., bond) in question.

(Liquidity risk premium is the premium added for the lack of liquidity of a bond. Higher the premium, lower the liquidity of the bond and vice versa)

4. B. Supply would decrease, leading to a shortage of funds and a higher market clearing interest rate.

(Since the number of lenders reduces, the supply of funds will decrease. Assuming demand remains the same, there will be a premium for the funds available and they will become dearer. This will increase the interest rates)