Deck 23: Credit Risk and the Value of Corporate Debt

Question 1

The interest rate on a one-year risk-free bond is 5 percent.BAC Company issued a 5 percent coupon bond with a face value of $1,000, maturing in one year.If the bond is considered risk-free, what is the price of the bond?

A)$1,050
B)$1,000
C)$985
D)$950

Answer 1

$1,000

Question 2

The U.S.federal government has guaranteed loans to the following industries:

A)housing.
B)housing and airlines.
C)housing, airlines, ship owners and shipyards, and steel companies.
D)housing, airlines, ship owners and shipyards, steel companies, and oil and gas companies.

Answer 2

housing, airlines, ship owners and shipyards, steel companies, and oil and gas companies.

Question 3

What is the most important difference between a corporate bond and an equivalent U.S.Treasury bond?

A)Corporate cash flow is relatively smooth, whereas U.S.government revenue is more variable.
B)Corporate bonds are traded on the floor of the New York Stock Exchange, and Treasury bonds trade in the over-the-counter market.
C)In the case of corporate bonds, firms have sometimes defaulted, whereas the U.S.government has not.
D)The beta of corporate bonds is usually less than the beta of a U.S.Treasury bond.

Answer 3

In the case of corporate bonds, firms have sometimes defaulted, whereas the U.S.government has not.

Question 4

Suppose that a bond with one-year maturity, a coupon rate of 5 percent, and face value of $1,000 sells for $881.94.Calculate the promised yield on the bond.

A)5.42 percent
B)8.07 percent
C)19.06 percent
D)5.67 percent

Question 5

Which of the following rated bonds has the most risk?

A)Aaa
B)Aa
C)Baa
D)Ba

Question 6

A corporate bond matures in one year.The bond promises a $50 coupon and a principal payment of $1,000 at maturity.If an investor buys the bond for $938.10, calculate the promised yield on the bond.

A)6.60 percent
B)11.93 percent
C)5 percent
D)5.33 percent

Question 7

If the discount rate on a bond is 7 percent and the expected payment in year 1 is $952.50, calculate the price of the bond.

A)$1,050
B)$985
C)$890
D)$935

Question 8

The value of a bond is given by

A)bond value = asset value - value of call option on assets.
B)bond value = asset value - value of call option on assets and bond value = value of an equivalent default-free bond + value of put option on assets.
C)bond value = value of an equivalent default-free bond + value of put option on the stock and bond value = asset value + value of call option on the stock.
D)bond value = asset value + value of call option on the stock.

Question 9

If the discount rate on a bond is 8 percent and the expected payment in year 1 is $952.50, calculate the price of the bond.

A)$1,050
B)$985
C)$907.14
D)$881.94

Question 10

A corporate bond matures in one year.The bond promises a $50 coupon and principal of $1,000 at maturity.Suppose the bond has a 10 percent probability of default and payment under default is $400.If an investor buys the bond for $907.14, calculate the promised yield on the bond.

A)6.6 percent
B)15.75 percent
C)5 percent
D)8.58 percent

Question 11

The average yield spread based on promised yield on Aaa bonds rated by Moody's and the yield on Treasuries is about

A)1 percent.
B)2 percent.
C)3 percent.
D)4 percent.

Question 12

If the discount rate on a bond is 5 percent and the expected payment in year 1 is $985, calculate the price of the bond.

A)$1,050
B)$985
C)$938.10
D)$1,000

Question 13

A corporate bond matures in one year.The bond promises a coupon of $50 and principal of $1,000 at maturity.If the bond has a 10 percent probability of default and payment under default is $400, calculate the expected payment from the bond.

A)$1,050
B)$400
C)$985
D)$1,000

Question 14

The value of a corporate bond can be thought of as

A)bond value without default - value of put.
B)bond value without default + value of put.
C)bond value without default + value of a stock.
D)bond value without default - value of call.

Question 15

The U.S.government agrees to guarantee a bond issue planned by Demurrage Associates (DA).The value of this guarantee

A)is a subsidy to DA's equity investors.
B)equals the value of the guaranteed loan minus the value of the loan without a guarantee, is a subsidy to DA's equity investors, and equals the value of a put option on the firm's assets with an exercise price equal to the bond's promised payments.
C)equals the value of the guaranteed loan minus the value of the loan without a guarantee.
D)is a windfall gain to the buyers of the bonds.

Question 16

Which of the following rated bonds has the least risk?

A)AAA
B)AA
C)A
D)BBB

Question 17

Generally, you can insure corporate bonds through a(n)

A)arrangement with the Treasury department.
B)arrangement with the state government.
C)credit default swap.
D)back-dated options contract.

Question 18

A corporate bond matures in one year.The bond promises a $50 coupon and a principal payment of $1,000 at maturity.If the bond has a 15 percent probability of default and payment under default is $400, calculate the expected payment from the bond.

A)$1,050
B)$400
C)$952.50
D)$892.50

Question 19

The value of a corporate bond can be thought of as

A)asset value - value of call option on assets.
B)asset value + value of call option on assets.
C)asset value + value of a default-free bond.
D)asset value - value of put option on assets.

Question 20

A corporate bond matures in one year.The bond promises interest of $50 and principal of $1,000 at maturity.Suppose the bond has a 10 percent probability of default and payment under default is $400.If an investor buys the bond for $890.19, calculate the promised yield on the bond.

A)6.6 percent
B)18 percent
C)7 percent
D)10.7 percent

Question 21

Investors can insure corporate bonds through an arrangement called a credit default swap.

Question 22

Use the following data: ROA = 10%; Total liabilities = 90% of assets; EBITDA = 10% of liabilities.Calculate the relative chance of failure using the following model: Log (relative chance of failure) = -6.445 - 1.192 ROA + 2.307 (liabilities/assets) - 0.346(EBITDA/liabilities).

A)1.70 percent
B)1.09 percent
C)0.16 percent
D)None of the options are correct.

Question 23

Generally, a corporate bond has a higher promised yield than the yield on a similar government bond.

Question 24

The value of a risky bond equals asset value - value of call option on assets.

Question 25

Generally, promised yields are at least as great as expected yields.

Question 26

An analyst predicts that at the 95 percent confidence level a bank could lose 7 percent of its asset value.Given assets of $30 million, what is the value at risk?

A)$2.1 million
B)$27.9 million
C)$28.5 million
D)$30 million

Question 27

Bonds rated below BBB (Baa) are termed junk bonds.

Question 28

The Z-score model was developed by Altman using

A)multiple discriminant analyses.
B)real options analysis.
C)hazard analysis.
D)None of the options are correct.

Question 29

During the period 1983-2012, the percentage of bonds that were rated AAA and remained AAA was

A)86.48 percent.
B)85.94 percent.
C)87.29 percent.
D)84.55 percent.

Question 30

The median total debt ratio (Total debt/(total debt + equity in %) for industrial firms with an A rating is

A)12.4 percent.
B)28.3 percent.
C)37.5 percent.
D)38.6 percent.

Question 31

The value of a government guarantee of a bond equals the value of a put option on the firm's assets.

Question 32

Bonds rated below BBB (Baa) are called

A)investment-grade bonds.
B)junk bonds.
C)default-free bonds.
D)intermediate bonds.

Question 33

It is extremely rare for a corporate bond to have a higher expected yield than a government bond.

Question 34

Floating-rate bonds have adjustable coupons to protect investors against changes in interest rates.The rates paid may be limited by

A)the put provisions of the issue.
B)a floor rate that sets the minimum.
C)a cap rate that sets the maximum.
D)both a floor rate that sets the minimum and a cap rate that sets the maximum.

Question 35

The three main bond rating agencies in the United States are

A)Moody's, Standard and Poor's, and A.M.Best.
B)Moody's, Standard and Poor's, and Dominion Bond.
C)Moody's, Standard and Poor's, and Fitch.
D)Moody's, Standard and Poor's, A.M.Best, Dominion Bond, and Fitch.

Question 36

Beaver, McNichols, and Rhie have developed the following model to predict the chance of failing during the next year relative to the chance of not failing for firms: log(relative chance of failure) = -6.445 - 1.192 ROA + 2.307 (liabilities/assets) - 0.346(EBITDA/liabilities), using

A)multiple discriminant analyses.
B)real options analysis.
C)hazard analysis.
D)None of the options are correct.

Question 37

The value of a risky bond equals value of a bond without default - value of a put option on assets.

Question 38

In 2012, the Greek government strong-armed private investors into replacing their existing bonds with new securities worth what percentage of their original bonds?

A)30 percent
B)40 percent
C)50 percent
D)60 percent

Question 39

The default rate on B rated bonds 10 years after issue is less than (choose best response)

A)5 percent.
B)10 percent.
C)20 percent.
D)45 percent.

Question 40

Commercial banks and several other financial institutions are not permitted to invest in bonds unless they are investment grade.What is the definition of an investment-grade bond?

A)One with a triple-A rating.
B)One with a rating of Baa or better.
C)One with a rating of B or better.
D)One with a rating of C or better.

Question 41

Briefly explain the model developed by Beaver, McNichols, and Rhie to predict the chance of failure of a firm.

Question 42

Briefly explain how the option pricing model can be used for pricing risky debt.

Question 43

Briefly describe bond ratings.

Question 44

Bonds rated BBB (Baa) and above are called junk bonds.

Question 45

What is a credit default swap? Briefly explain.

Question 46

Briefly explain how governmental loan guarantees can be valued using the option pricing model.

Question 47

Investment-grade bonds can usually be entered at face value on the books of banks and life insurance companies.

Question 48

The value of a firm's right to default on a bond generally increases with the maturity of the bond.

Question 49

Briefly explain the term credit scoring.

Question 50

Briefly explain the term junk bonds.

Question 51

What is a major drawback to value-at-risk calculations?

Question 52

Suppose that the possibility of default on a firm's bond is totally unrelated to other events in the economy.In this case, the beta of the bond will equal zero and the discount rate will equal the risk-free rate.

Question 53

Define the term credit risk.