Chap023.pdf

Chapter 23 - Credit Risk and the Value of Corporate Debt

Chapter 23 Credit Risk and the Value of Corporate Debt Multiple Choice Questions

1. The interest rate on one-year risk-free bond is 5%. BAC company has issued a 5% 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. none of the above

2. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, calculate the expected payment from the bond. A. $1,050 B. $400 C. $985 D. None of the above

3. If the discount rate on the bond is 5%, the expected payment in year-1 is $985; calculate the price of the bond: A. $1050 B. $985 C. $938.10 D. none of the given answers

A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity.

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4. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $938.10. Calculate the promised yield on the bond. (assume no default) A. 6.6% B. 11.93% C. 5.0% D. None of the given values

5. If the bond has 15% 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. none of the above

6. If the discount rate on the bond is 8%, the expected payment in year-1 is $952.50; calculate the price of the bond: A. $1050 B. $985 C. $907.14 D. none of the given answers

7. If a bond with one year maturity with a coupon rate of 5% and face value of $1,000 is selling for $881.94. Calculate the promised yield on the bond. A. 5% B. 8% C. 19.06% D. none of the above

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8. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $907.14. Calculate the promised yield on the bond. A. 6.6% B. 15.75% C. 5.0% D. None of the given values

9. If the discount rate on the bond is 7%, the expected payment in year-1 is $952.50; calculate the price of the bond: A. $1050 B. $985 C. $890.19 D. none of the given answers

10. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at maturity. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $890.19; Calculate the promised yield on the bond. A. 6.6% B. 17.95% C. 7.0% D. None of the given values

11. What is the most important difference between a corporate bond and an equivalent Treasury bond? A. Corporate bond payments are made by a check from the firm and Treasury bonds are paid by printing money by the government. B. Corporate bonds are traded on the floor of New York Bond Market and Treasury bonds trade in the over-the-counter market. C. In the case of the corporate bond, the firm has the option to default whereas the government supposedly doesn't. D. None of the above.

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12. The average yield spread based on promised yield on AAA bonds rated by moody's and the yield on Treasuries is about: A. 1% B. 2% C. 5% D. none of the above

13. Generally, you can insure corporate bonds through: A. an arrangement with the Treasury department B. an arrangement with the state government C. credit default swap D. none of the above

14. The value of a bond that has a probability of default is given by: I) bond value = asset value - value of call option on assets II) bond value = value of an equivalent default-free bond + value of put option on assets III) bond value = value of an equivalent default-free bond + value of put option on the stock IV) bond value = asset value + value of call option on the stock A. I only B. I and II only C. III and IV only D. IV only

15. 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. None of the above

16. The value of a corporate bond can be thought of as: A. Asset value - value of call on assets B. Asset value + value of call on assets C. Asset value + value of a default free bond D. None of the above

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17. The US government agrees to guarantee a bond issue planned by Demurrage Associates. The value of this guarantee: I) Value of the loan with guarantee minus value of the loan without guarantee II) Is a subsidy to equity investors in the firm issuing guaranteed debt III) Is a windfall gain to the buyers of the bonds IV) Equals the value of a put option on the firm's assets with an exercise price equal to the bond's face value A. II only B. I, II, and IV C. I only D. III only

18. Federal government loan guarantees include the following: I) housing II) airlines III) shipowners and shipyards IV) steel companies V) oil and gas companies A. I only B. I and II only C. I, II, III and IV only D. I, II, III, IV and V

19. Which of the following rated bonds have the least risk? A. AAA B. AA C. A D. BBB

20. Which of the following bonds have the least risk? A. AAA B. AA C. BAA D. BA

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21. 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

22. Bonds rated below BBB (Baa) are called: A. Investment grade bonds B. Junk bonds C. Default-free bonds D. None of the above

23. The three main bond rating agencies in the USA are: I) Moody's II) Standard and Poor's III) A.M. Best IV) Dominion Bond V) Fitch A. I, II and III B. I, II and IV C. I, II and V D. I, II, III, IV and V

24. In 2001, what percentage of junk bond issues defaulted? A. 6.2% B. 11.0% C. 15.6% D. 24.0%

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25. The default rate on BBB rated bonds ten years after the issue is: A. 0.3% B. 3.1% C. 6.6% D. 24.0%

26. The median TIE (EBIT/interest) ratio for industrial firms with AAA bond ratings is: A. 23.8 B. 19.5 C. 8.0 D. 4.7

27. The median total debt ratio (Total debt/(total debt + equity in %) for industrial firms with A rating is: A. 12.4% B. 28.3% C. 37.5% D. 42.5%

28. Beaver, McNichols and Rhie have developed the following model to predict the chance of failing during the next year relative to 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 analysis B. real options analysis C. hazard analysis D. none of the above

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29. Given the following data: ROA = 10%; total liabilities = 90% of the 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. 1.7% B. 1.09% C. 0.16% D. none of the above

30. Z-score model was developed by Altman using: A. multiple discriminant analysis B. real options analysis C. hazard analysis D. none of the above

31. Between 1981-2008, the percentage of bonds that were rated AAA remained AAA was (Approximately): A. 88.39% B. 87.06% C. 87.22% D. None of the above

32. An analyst predicts that at the 95% confidence level a bank could lose 7% of its asset value. Given assets of $30 million, what is the value at risk? A. $2.1 mil B. $7.0 mil C. $28.5 mil D. $30 mil

33. Banks concerned about risk of loss, may measure Value-at-Risk over what time period? A. 1 day B. 1 week C. 1 month D. all of the above

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True / False Questions

34. Generally, a corporate bond has a higher promised yield than a government bond. True False

35. Generally, a corporate bond has a higher expected yield than a government bond. True False

36. Investors can insure corporate bonds through an arrangement called credit default swap. True False

37. The value of a risky bond is equal to: asset value - value of call option on assets. True False

38. The value of a risky bond is equal to: value of a bond without default - value of a put option on assets. True False

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

40. Bonds rated below BBB (Baa) are termed "Junk bonds." True False

41. Bonds rated BBB (Baa) and above are called "Junk bonds." True False

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

43. The value at risk of a bank can change with the risk tolerance of the bank. True False

44. A value at risk calculation requires some level of statistical confidence level expressed by the firm.

True False

Short Answer Questions

45. Define the term "credit risk."

46. What is credit default swap? Briefly explain.

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47. Briefly explain how the Option pricing model can be used for pricing risky debt?

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

49. Briefly explain bond ratings.

50. Briefly explain the term junk bonds.

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51. Briefly explain the term "credit scoring."

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

53. What is a major drawback to value at risk calculations?

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Chapter 23 Credit Risk and the Value of Corporate Debt Answer Key

Multiple Choice Questions

1. The interest rate on one-year risk-free bond is 5%. BAC company has issued a 5% 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. none of the above Price = 1,050/1.05 = 1,000

Type: Easy

2. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, calculate the expected payment from the bond. A. $1,050 B. $400 C. $985 D. None of the above Expected payment = 1050(0.9) + 400(0.1) = $985

Type: Easy

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3. If the discount rate on the bond is 5%, the expected payment in year-1 is $985; calculate the price of the bond: A. $1050 B. $985 C. $938.10 D. none of the given answers PV = 985/(1.05) = 938.10

Type: Easy

A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity.

4. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $938.10. Calculate the promised yield on the bond. (assume no default) A. 6.6% B. 11.93% C. 5.0% D. None of the given values Promised yield = 1050/938.10 = 11.93%

Type: Medium

5. If the bond has 15% 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. none of the above Expected payment = 1050(0.85) + 400(0.15) = $952.50

Type: Easy

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6. If the discount rate on the bond is 8%, the expected payment in year-1 is $952.50; calculate the price of the bond: A. $1050 B. $985 C. $907.14 D. none of the given answers PV = 952.50/(1.05) = 881.94

Type: Easy

7. If a bond with one year maturity with a coupon rate of 5% and face value of $1,000 is selling for $881.94. Calculate the promised yield on the bond. A. 5% B. 8% C. 19.06% D. none of the above Promised yield = (1050/881.94) - 1 = 19.06%

Type: Easy

8. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at the time of maturity. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $907.14. Calculate the promised yield on the bond. A. 6.6% B. 15.75% C. 5.0% D. None of the given values Promised yield = 1050/907.14 = 15.75%

Type: Medium

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9. If the discount rate on the bond is 7%, the expected payment in year-1 is $952.50; calculate the price of the bond: A. $1050 B. $985 C. $890.19 D. none of the given answers PV = 952.50/(1.07) = 890.19

Type: Easy

10. A corporate bond has one-year maturity. The bond pays an interest of $50 and principal of $1,000 at maturity. If the bond has 10% probability of default and payment under default is $400, and an investor buys the bond for $890.19; Calculate the promised yield on the bond. A. 6.6% B. 17.95% C. 7.0% D. None of the given values Promised yield = 1050/890.19 = 17.95%

Type: Medium

11. What is the most important difference between a corporate bond and an equivalent Treasury bond? A. Corporate bond payments are made by a check from the firm and Treasury bonds are paid by printing money by the government. B. Corporate bonds are traded on the floor of New York Bond Market and Treasury bonds trade in the over-the-counter market. C. In the case of the corporate bond, the firm has the option to default whereas the government supposedly doesn't. D. None of the above.

Type: Easy

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12. The average yield spread based on promised yield on AAA bonds rated by moody's and the yield on Treasuries is about: A. 1% B. 2% C. 5% D. none of the above

Type: Medium

13. Generally, you can insure corporate bonds through: A. an arrangement with the Treasury department B. an arrangement with the state government C. credit default swap D. none of the above

Type: Medium

14. The value of a bond that has a probability of default is given by: I) bond value = asset value - value of call option on assets II) bond value = value of an equivalent default-free bond + value of put option on assets III) bond value = value of an equivalent default-free bond + value of put option on the stock IV) bond value = asset value + value of call option on the stock A. I only B. I and II only C. III and IV only D. IV only

Type: Difficult

15. 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. None of the above

Type: Medium

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16. The value of a corporate bond can be thought of as: A. Asset value - value of call on assets B. Asset value + value of call on assets C. Asset value + value of a default free bond D. None of the above

Type: Medium

17. The US government agrees to guarantee a bond issue planned by Demurrage Associates. The value of this guarantee: I) Value of the loan with guarantee minus value of the loan without guarantee II) Is a subsidy to equity investors in the firm issuing guaranteed debt III) Is a windfall gain to the buyers of the bonds IV) Equals the value of a put option on the firm's assets with an exercise price equal to the bond's face value A. II only B. I, II, and IV C. I only D. III only

Type: Medium

18. Federal government loan guarantees include the following: I) housing II) airlines III) shipowners and shipyards IV) steel companies V) oil and gas companies A. I only B. I and II only C. I, II, III and IV only D. I, II, III, IV and V

Type: Medium

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19. Which of the following rated bonds have the least risk? A. AAA B. AA C. A D. BBB

Type: Easy

20. Which of the following bonds have the least risk? A. AAA B. AA C. BAA D. BA

Type: Easy

21. 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

Type: Easy

22. Bonds rated below BBB (Baa) are called: A. Investment grade bonds B. Junk bonds C. Default-free bonds D. None of the above

Type: Easy

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23. The three main bond rating agencies in the USA are: I) Moody's II) Standard and Poor's III) A.M. Best IV) Dominion Bond V) Fitch A. I, II and III B. I, II and IV C. I, II and V D. I, II, III, IV and V

Type: Medium

24. In 2001, what percentage of junk bond issues defaulted? A. 6.2% B. 11.0% C. 15.6% D. 24.0%

Type: Easy

25. The default rate on BBB rated bonds ten years after the issue is: A. 0.3% B. 3.1% C. 6.6% D. 24.0%

Type: Easy

26. The median TIE (EBIT/interest) ratio for industrial firms with AAA bond ratings is: A. 23.8 B. 19.5 C. 8.0 D. 4.7

Type: Easy

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27. The median total debt ratio (Total debt/(total debt + equity in %) for industrial firms with A rating is: A. 12.4% B. 28.3% C. 37.5% D. 42.5%

Type: Easy

28. Beaver, McNichols and Rhie have developed the following model to predict the chance of failing during the next year relative to 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 analysis B. real options analysis C. hazard analysis D. none of the above

Type: Medium

29. Given the following data: ROA = 10%; total liabilities = 90% of the 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. 1.7% B. 1.09% C. 0.16% D. none of the above

Type: Medium

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30. Z-score model was developed by Altman using: A. multiple discriminant analysis B. real options analysis C. hazard analysis D. none of the above

Type: Medium

31. Between 1981-2008, the percentage of bonds that were rated AAA remained AAA was (Approximately): A. 88.39% B. 87.06% C. 87.22% D. None of the above

Type: Easy

32. An analyst predicts that at the 95% confidence level a bank could lose 7% of its asset value. Given assets of $30 million, what is the value at risk? A. $2.1 mil B. $7.0 mil C. $28.5 mil D. $30 mil 30 mil x 07 = 2.1 mil

Type: Easy

33. Banks concerned about risk of loss, may measure Value-at-Risk over what time period? A. 1 day B. 1 week C. 1 month D. all of the above

Type: Easy

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True / False Questions

34. Generally, a corporate bond has a higher promised yield than a government bond. TRUE

Type: Easy

35. Generally, a corporate bond has a higher expected yield than a government bond. FALSE

Type: Medium

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

Type: Medium

37. The value of a risky bond is equal to: asset value - value of call option on assets. TRUE

Type: Difficult

38. The value of a risky bond is equal to: value of a bond without default - value of a put option on assets. TRUE

Type: Difficult

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

Type: Medium

40. Bonds rated below BBB (Baa) are termed "Junk bonds." TRUE

Type: Easy

41. Bonds rated BBB (Baa) and above are called "Junk bonds." FALSE

Type: Easy

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

Type: Difficult

43. The value at risk of a bank can change with the risk tolerance of the bank. TRUE

Type: Medium

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44. A value at risk calculation requires some level of statistical confidence level expressed by the firm.

TRUE

Type: Medium

Short Answer Questions

45. Define the term "credit risk." Credit risk or default risk is the risk that payments on a security will not be made under the original contract terms.

Type: Medium

46. What is credit default swap? Briefly explain. Credit default swap is an arrangement using which investors can insure corporate bonds. If an investor buys a credit default swap, he/she commits to pay regular insurance premium or spread. In return, if the firm subsequently defaults on its debt, the seller of the swap pays the investor the difference between the face value of the debt and its market value. Credit default swaps have proved very popular, particularly with banks that need to reduce the risk of their loan on books. From almost nothing in 2000, the notional value of default swaps and related products has increased to $26 trillion in 2006.

Type: Difficult

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47. Briefly explain how the Option pricing model can be used for pricing risky debt? The value of a risky debt can be thought of as the value of an equivalent risk-free debt less the value of a put option. Also, bond value can be thought of as the value of the assets of a firm minus the value of call option on assets. Conceptually this is an attractive way to price risky bonds. But in practice it is quite complicated.

Type: Difficult

48. Briefly explain how government loan guarantees can be valued using the option pricing model. Value of guarantee = loan value with the guarantee - loan value without the guarantee. The loan guarantee can be valued as a put option on the firm's assets, where the put's maturity is the maturity of the loan and its exercise price equals the interest and principal payments promised to the lenders.

Type: Medium

49. Briefly explain bond ratings. Bond ratings are a qualitative measure of a bond's default risk. Moody's, Standard & Poor's and Fitch assign these ratings for a fee. AAA (S&P) or Aaa (Moody's) rated bonds have the least default risk. Bonds rated BBB (Baa) and above are known as investment grade bonds. Bonds rated below BBB (Baa) are known as junk bonds as these have high default probabilities.

Type: Medium

50. Briefly explain the term junk bonds. Bonds rated below BBB (Baa) are known as junk bonds. These bonds have high default risk. The yield on these bonds is also high. Junk bonds are also issued to finance LBOs.

Type: Easy

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51. Briefly explain the term "credit scoring." Credit scoring is used to distinguish between good credits and bad credits. Credit scoring models are used to do this analysis. These models are used by banks, credit card companies and businesses to assess the credit rating of their clients or customers before providing loans or extending credit facilities. There are several credit rating agencies that provide the information.

Type: Medium

52. Briefly explain the model developed by Beaver, McNichols and Rhie to predict the chance of failure of a firm. Beaver, McNichols and Rhie have developed an empirical model to predict the relative chance of failure of a firm during the next year relative to the chance of not failing. It is given by the following model: log(relative chance of failure) = -6.445 - 1.192 ROA + 2.307 (liabilities/assets) - 0.346(EBITDA/liabilities) It is based on three ratios: ROA, liabilities/assets and EBITDA/liabilities. Using this model we can see that the relative chance of failure for Ford in 2007 is 1.7%.

Type: Medium

53. What is a major drawback to value at risk calculations? The calculation of value at risk requires a level of subjective input. The firm must determine the confidence level of the risk measurement as well as the time frame being covered. A firm requiring a VAR at the 99% confidence level over a one day time period is much more risk averse than a firm requiring a VAR at the 95% confidence level over one month.

Type: Difficult

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Chap023.pdf

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