16. If you look in the financial pages of the newspaper, you will see that inter

Question

16. If you look in the financial pages of the newspaper, you will see that interest rates differ dramatically for different bonds. For each of the following situations, which bond would you expect to have a higher interest rate? Explain your reasoning.

A) A U.S government bond or a bond issued by Ford Motor Company, given that the market for U.S government bonds is more liquid.

B) A U.S government bond or a bond issued by IBM Corp., given that state and local governments cannot tax the interest earned on U.S. government bonds.

C) A bond issued by Microsoft Corporation or by Microsmart.com, given that Microsmart.com is near bankruptcy.

D) A 3-month government bond or a 30-year government bond, given that investors prefer short-term investments.

Explanation / Answer

A) bond issued by Ford Motor Company because it has greater default risk. Govt bonds are considered risk free since they can always pay their bonds by increasing taxes.

B) IBM Corp, as the issuer has to compensate the investor for additional taxes paid on the coupon to make the bonds enticing for investment

C) Microsmart.com because of greater default risk

D) 30-year government bond, greater the maturity greater is the maturity premium commanded by the investor

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