8008 Exam Dumps : PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition

Explantion:

Changing leverage does not affect the Sharpe ratio or the Information ratio. However, leverage magnifies both risk and return. Therefore Choice 'b' is the correct answer.Recall that Sharpe ratio is the ratio of the excess returns (over the risk free rate) of an investment to its standard deviation, and the information ratio is the ratio of the 'alpha' returns to the standard deviation of such returns.

The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be

= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))

=> p*0 + (1 - p)*(1 + 8.5%) = (1 - p)*1.085.

The cash flows from the treasury bond would be 1.04. These two should be equal, ie,

1.04 = (1- p)*1.085, implying p = 4.15%.

(Note: The above is a simplification intended for the exam. In reality investors would demand a 'credit risk premium' for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)

The difference between the yields on corporate bonds and the risk free rate is called the corporate bond spread. Widening of the spread means that corporate bonds yield more, and their yield curve shifts upwards, driving down bond prices. The increase in the spread is a consequence of the market risk from holding these interest rate instruments, which is a part of market risk. If the reduction in the value of the portfolio were to be caused by a change in the credit rating of the bonds held, it would have been a loss arising due to credit risk. Counterparty risk and liquidity risk are not relevant for this question. Therefore Choice 'c' is the correct answer.