Question

1) Which of the following two statements is correct? S1: The real risk-free rate of return captures a bond’s liquidity risk. S2: Holding all else equal, bonds with call provisions are more likely to get called by the bond issuer after substantial interest rate increases.

Group of answer choices

Both statements are true

S2 is true but S1 is false

S1 is true but S2 is false

Both statements are false

2) Which of the following statements is correct?

S1: Holding all else unchanged, as a result of price risk the interest rates for long-term bonds are lower than the interest rates for short-term bonds.

S2: Reinvestment risk of a short-term bond is lower than the reinvestment risk of a long-term bond.

Group of answer choices

S1 is true but S2 is false

Both statements are true

Both statements are false

S2 is true but S1 is false

Answer 1

1.

S1: Incorrect: The risk free rate does not capture liquidity risk. Even the proxy risk free rate is usually taken as through a Treasury bond which is free of liquidity. Further, most of the times, the liquidity risk impacts those bonds that have high yields, which reflects that it is not a component of risk free rate.

S2: Incorrect: Bonds are most likely called when interest rates move lower. This allows the investors to reinvest at a higher rate.

Thus, Both Statements are False.

2.

S1: Incorrect - The interest rates of longer term bonds are actually higher than short term bonds. This is due to the fact that longer term bonds have greater duration and are more impacted by the changes in interest rates (and prices)

S2: Incorrect - Reinvestment risk for a short term bond is higher because cash for reinvestment becomes available more quickly as opposed to a long term bond.

Thus, Both Statements are False