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3、Six months ago an investor purchased a bond that was rated BB. Today the bond is upgraded to a BBB rating. The most likely effect of this upgrade is:

A) an increase in yield to maturity.

B) increased liquidity risk.

C) increased call risk.

D) a higher spot price.

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The correct answer is D

An increase in spot price is the most likely effect of an upgrade. This higher price will lead to a decrease in YTM. Liquidity risk will be lower as the bond will now be classified as an investment grade bond, and therefore would be an allowable investment for an increased number of pension plans and mutual funds. Increased call risk may be possible if the rating upgrade was due to an improved financial situation for the company, but without more information this cannot be determined.

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AIM 4: Explain and compare the through-the-cycle and at-the-point approaches to score a company.

1、Which of the following internal rating credit systems develop ratings for long time horizons (more than one year)?

I.           At-the-point approach.

II.         Through-the-cycle approach.

A) II only.

B) I only.

C) I and II.

D) Neither I nor II.

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The correct answer is A

The at-the-point approach predicts credit quality over a relatively short horizon, while through-the-cycle methodology focuses on a long time horizon.

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2、Which of the following internal rating credit systems is more likely to be procyclical (i.e., tend to amplify the business cycle)?

At-the-point approach.

Through-the-cycle approach.

A) I only.

B) II only.

C) I and II.

D) Neither I nor II.

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The correct answer is C

Bond prices are more affected by ratings changes. The effect on stock prices is mixed (e.g., a downgrade can produce a higher stock price).

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2、Which of the following statements is TRUE?

A) Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture.

B) When a rating agency downgrades a security, the bond's price usually falls.

C) Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

D) Bond ratings are determined by the market.

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The correct answer is B

The market will likely demand a higher yield from the downgraded bond (the risk premium has increased) and thus the price will likely fall. Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder (lender) may recover some or all of the investment through legal action or negotiation. The percentage recovered is known as the recovery rate. Rating agencies such as Moody’s and Standard and Poor’s assign bond ratings. The market reflects these ratings through a higher or lower market yield.

aianjie

 

The correct answer is C

Bonds rated Baa and above are considered investment grade, and those rated Ba and below are non-investment grade.

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2、Historically, the relationship for external ratings in predicting default has been:

A) fairly good in that poorly rated firms do have higher default rates. 

B) non-existent.

C) opposite to what the ratings would indicate and significant.

D) opposite to what the ratings would indicate but not significant.