Final answer:
If market interest rates rise by 0.05% overnight, the investment bank would likely need to sell the underwritten bonds at a discount, reducing their profits. The drop in profits corresponds to the size of the discount required to make the bonds attractive to buyers in the new interest rate environment.
Step-by-step explanation:
The question pertains to the potential impact on an investment bank's profits if interest rates rise overnight after they have underwritten a bond issue on a firm commitment basis. When the investment bank commits to underwriting a $500 million, 10-year, 8% semiannual coupon bond issue at par for ABC Corporation, they are taking on the risk associated with changes in market interest rates.
If the market interest rates rise by 0.05% overnight, the newly issued bonds become less attractive to potential investors, since they might prefer newly issued bonds with higher rates that reflect the new market conditions. To sell the bonds, the investment bank may have to sell them at a discount. Since the investment bank has already paid ABC Corporation for these bonds, any discount on the sale price directly reduces the investment bank's profits. The exact loss in profit would depend on the size of the discount necessary to sell the bonds in a higher interest rate environment.
For example, consider a scenario where interest rates in the economy increase significantly after the bond is issued. If the bond carries no risk (i.e., it is assumed that the issuer will not default), the bond would originally sell at par value of $1,000 and pay an $80 per year coupon. A dramatic rise in interest rates to 12% would make the bond unattractive, and the bond's price would have to be reduced to entice investors. This illustrates how sensitive bond prices are to changes in interest rates.