Question

As the liquidity of corporate bonds decreases, what happens to the risk premium required on those bonds?

1) Increases
2) Decreases
3) Remains the same
4) Cannot be determined

Answer 1

As the liquidity of corporate bonds decreases, the risk premium required on those bonds typically increases. This is because investors demand a higher return for holding bonds that are less liquid and potentially harder to sell in the market. Therefore, the correct answer is 1) Increases.

Answer 2

As the liquidity of corporate bonds decreases, the risk premium required on those bonds increases (option 1).

Step-by-step explanation:

The risk premium on corporate bonds is influenced by several factors, and liquidity is a critical component. Liquidity refers to the ease with which an asset, in this case, corporate bonds, can be bought or sold in the market without affecting its price negatively. When the liquidity of corporate bonds decreases, investors may face challenges in buying or selling these bonds quickly and at a fair market price. This illiquidity introduces an additional risk for investors, as they may not be able to exit their positions easily if market conditions change.

To compensate for the increased risk associated with less liquid corporate bonds, investors demand a higher risk premium. The risk premium is the additional return investors require above the risk-free rate to hold a riskier asset. In the context of corporate bonds, the risk premium serves as compensation for bearing the added risk of illiquidity.

Therefore, as the liquidity of corporate bonds decreases, the risk premium must increase(option 1) to attract investors and compensate them for the higher level of risk they are taking. This relationship between liquidity and the risk premium is a crucial aspect of financial markets and investment decision-making.