The New Lombard Street, Merhling (2011) quotes Fischer Black(1970) in saying: Th

Question

The New Lombard Street, Merhling (2011) quotes Fischer Black(1970) in saying:
Thus a long term corporate bond could actually be sold to three separate persons. One would
supply the money for the bond; one would bear the interest rate risk; and one would bear the risk
of default. The last two would not have to put up any capital for the bonds, although they might
have to post some sort of collateral.

How does the separation of risk work? What financial instruments are needed? Give an explanation so
that someone with no training in economics could understand.

Explanation / Answer

Default risk : Default risk is exposure to loss due to non-payment by a borrower of a financial obligation when it becomes payable. Default risk is related to the credit worthiness of the borrower and is taken into account when setting interest rate on the requested loan.

Collaterals: Collateral is an additional form of security which can be used to assure a lender that you have a second source of loan repayment. Assets such as equipment, buildings, accounts receivable, and (in some cases) inventory are considered possible sources of repayment if they can be sold by the bank for cash.

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as protection for a lender against a borrower's default—that is, any borrower failing to pay the principal and interest under the terms of a loan obligation.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.