Suppose that a 5-year Treasury bond pays an annual rate of return of 1.5%, and a
ID: 2428613 • Letter: S
Question
Suppose that a 5-year Treasury bond pays an annual rate of return of 1.5%, and a 5-year bond of the fictional company Risky Investment Inc. pays an annual rate of return of 6.5%. The risk premium on the Risky Investment bond ispercentage points. - Consider an increase in the annual rate of return on the Risky Investment bond from 6.5 percent to 8.1 percent. Such a change would the interest rate spread on the Risky Investment bond over Treasuries to Which of the following explains the increase in the annual rate of return on the Risky Investment bond? The expected default rate on the Treasury bond has decreased O The expected default rate on the Risky Investment bond has increased. O The expected default rate on the Risky Investment bond has decreased. The expected default rate on the Treasury bond has increasedExplanation / Answer
Annual rate of return on 5-year Treasury bond = 1.5%
Annual rate of return on 5-year bond of Risky Investment Inc. = 6.5%
Calculate the risk premium on the Risky Investment Inc. -
Risk premium = Annual rate of return on 5-year bond of Risky Investment Inc. - Annual rate of return on 5-year Treasury bond
Risk premium = 6.5% - 1.5% = 5%
Thus,
The risk premium on the Risky Investment bond is 5 percentage points.
Now, annual rate of return on Risky Investment bond increases to 8.1 percent.
Spread = 8.1% - 1.5% = 6.6%
Thus,
Such a change would increase the interest rate spread on the Risky Investment bond over Treasuries 6.6 percentage points.
Increase in expected default rate can lead to increase in interest rate offered on a bond.
So,
The increase in the annual rate of return on the Risky Investment bond is due to the increase in the expected default rate on the Risky Investment Bond.
Hence, the correct answer is the option (2).
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