Question

Using a supply and demand model for bonds, answer the following questions regarding bonds issued by Apple:

1. Show the effects of an increase in the default risk of Apple. Explain why this is the case.
2. Show the effects if Apple’s bond rating goes from AA to AAA. Explain how bond ratings work.

Answer 1

Answer:

Using a supply and demand model for bonds,

the effects of an increase in the default risk of Apple:

explanation:

Increase in the default risk of Apple win make Apple a risky investment option.

Since people are generally risk averse, an increase in the risk rate of Apple will make people shy away from investing in Apple bonds.

Asa result, demand for Apple bonds will decrease, thereby leading to a leftward shift in the demand curve for Apple bonds.

This can be seen as below,

Graph:

This leads to a fall in both interest rate on bond as well as their quantity traded in the market

the effects if Apple’s bond rating goes from AA to AAA:

explanation:

Increase in the Apple bond rating florn AA to AAA means Apple has become less risky Investment option.

Since people are generally risk averse, an increase in the bond rating of will will make people invest more in Apple bonds as they ham now become safer.

As a result, demand for Apple bonds will increase, thereby leading to a rightward shift in the demand curve for Apple bonds.

This can be seen .below:

Graph:

This leads to an increase in both interest rate on bonds as well as their quantity traded in the market.

Bond rating:
Bond ratings work by assessing the market performance and risk associated with that investment option.

As the option becomes less risky and safe to bet upon, based on past performance, to rating improves. AAA A the highest rating.