When Investors Doubt the Creditworthiness of a Borrower

Question:

When investors doubt the creditworthiness of a borrower, how do they alter their calculation of the bond yield to take into account these doubts?

A. Investors do not alter the calculation.

B. Investors exclude future repayments they think will not occur.

C. Investors add the percent likelihood of bankruptcy to the yield.

D. Investors decrease the price by the percent likelihood of bankruptcy

Answer:

The correct option is C. Investors add the percent likelihood of bankruptcy to the yield.

Explanation:

Option C, where investors add the percent likelihood of bankruptcy to the yield, is the closest option to describing the correct answer. However, the percent likelihood of default is not typically added directly to the result but is used to calculate the risk premium.
In general, the higher the perceived risk of default, the higher the risk premium demanded by investors and the higher the bond yield. Conversely, if investors have confidence in the borrower’s creditworthiness, they may require a lower risk premium and a lower bond yield.

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