Consider four different financial products you can invest in: 1. A 12-month certificate of deposit that earns 2% annual interest. 2. A par 1-year risk-free bond with a 2% annual coupon. 3. A par 1-year risky bond with a 3.5% annual coupon. 4. A $100 per share value stock that typically pays a 2–4% dividend annually. Question 1 Which of these has credit risk? State at least 2 reasons WHY you selected one or more securities OR why you did NOT select the other one/ones.
Question
Consider four different financial products you can invest in:
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A 12-month certificate of deposit that earns 2% annual interest.
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A par 1-year risk-free bond with a 2% annual coupon.
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A par 1-year risky bond with a 3.5% annual coupon.
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A $100 per share value stock that typically pays a 2–4% dividend annually.
Question 1 Which of these has credit risk? State at least 2 reasons WHY you selected one or more securities OR why you did NOT select the other one/ones.
Solution
The financial product that has credit risk among the four options is the 1-year risky bond with a 3.5% annual coupon.
Reason 1: Credit risk is the risk that the borrower will default on their obligations to repay the debt. In this case, the bond is explicitly labeled as "risky", which implies a higher probability of the issuer defaulting on their payments compared to a risk-free bond.
Reason 2: Unlike the certificate of deposit and the risk-free bond, which are backed by the government or a financial institution with a very low risk of default, the risky bond is likely issued by a corporation or a government with a less stable financial situation. This increases the risk of default.
The stock also does not have credit risk because it represents ownership in a company, not a loan to the company. The risk in stocks is more about market risk - the risk that the price of the stock will go down - rather than credit risk. The dividend payment can vary based on the company's profits, but this is not considered a default if the company decides not to pay a dividend.
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Consider four different financial products you can invest in: 1. A 12-month certificate of deposit that earns 2% annual interest. 2. A par 1-year risk-free bond with a 2% annual coupon. 3. A par 1-year risky bond with a 3.5% annual coupon. 4. A $100 per share value stock that typically pays a 2–4% dividend annually. Question 3 Which of these has the highest expected return? State at least 2 reasons WHY you selected one or more securities OR why you did NOT select the other one/ones.
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