Seongjae Lee ManEc 453 Money, Banking and Financial Markets Problem set #5 Due: October 12, 2011 1. Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle-expansions and increase during recessions. Why is this so? During business cycle-expanstion, there's low default risk on corporate bonds, so risk premiums decrease. In contrast, during recessions, there's high default risk on the bonds, so the risk premiums inrease. 2. Under what circumstances would purchasing a Treasury Inflation Protected Security (TIPS) from the US government be virtually risk free? The US government pays fixed interest rate plus the change in CPI. So, there is no inflation risk. And since the US Treasury issues these bonds, there is no defualt risk. If there's a high possibility of high inflation and also recessions are expected, it is safe to purchase TIPS. 3. explain what will happen to bond prices and interest rates if the government
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