(Solved): PART THREE Valuation of Securities Several factors influence a bond's risk premium. The financial co ...

PART THREE Valuation of Securities Several factors influence a bond's risk premium. The financial condition of the borrower as measured by some of the ratios we studied in Chapter 3 ( e.gr, profitability ratios, debt ratios, interest coverage ratios) is related to the likelihood that a corporation will fail to make payments on its bonds, called default risk or credit risk. As the chapter opener explained, Aston Martin paid a much higher risk premium on its bonds than did Apple because Aston Martin's finan. cial condition was tenuous, whereas Apple's finances were rock solid. Different bonds issued by the same company may have different risk premiums as well. In its 2019 bond sale, Apple issued several different bonds that varied in terms of maturity and other features, and based on those characteristics the risk premiums on the bonds ranged from

to

above the Treasury rate at the time, Finally, when interest rates in the economy change, bond prices move in the op. posite direction, a phenomenon called interest rate risk. Some bonds are more sensitive to interest rate risk and therefore pay higher risk premiums to compen. sate investors for that risk.

REVIEW QUESTIONS 6-1 What is the real rate of interest? Differentiate it from the nominal rate of interest. 6-2 What is the term structure of interest rates, and how is it related to the yield curve? 6-3 What does each of the following yield curves reflect about interest rates: (a) downward sloping, (b) upward sloping, and (c) flat? What is the "normal" shape of the yield curve? 6-4 Briefly describe the following theories of the general shape of the yield curve: (a) expectations theory, (b) liquidity preference theory, and (c) market segmentation theory. 6-5 List and briefly describe the potential issuer- and issue-related risk components that are embodied in the risk premium.