Looking for the answer to the question below related to Financial Management ?
If the credit quality of the issuer deteriorates, market expects
|A. Lesser rate of interest
B. Higher rate of interest
C. Zero rate of interest
D. None of these
The Correct Answer Is:
- B. Higher rate of interest
Option B is correct because when the credit quality of the issuer deteriorates, the market typically expects a higher rate of interest. This is due to the increased risk associated with investing in bonds or securities issued by an entity with poor creditworthiness.
When an issuer’s credit quality deteriorates, it means that their ability to meet their financial obligations, such as paying interest and principal on their debt, is compromised.
This increases the perceived risk of default on the part of the issuer. In response to this increased risk, investors demand higher returns to compensate for taking on the additional credit risk.
A higher rate of interest serves as a risk premium that investors require in exchange for investing in bonds or securities of lower credit quality issuers. This compensates them for the possibility of not receiving their expected interest payments or the full repayment of their principal amount.
By raising the interest rate, issuers can attract investors despite their deteriorating credit quality.
Now let’s examine why the other options are not correct:
A. Lesser rate of interest:
When the credit quality of the issuer deteriorates, it is unlikely that the market would expect a lesser rate of interest. Lesser rates of interest would imply lower returns for investors, which would not adequately compensate for the increased risk associated with investing in lower credit quality securities.
Investors are typically risk-averse and demand higher returns when faced with higher credit risk.
C. Zero rate of interest:
Expecting a zero rate of interest when the credit quality of the issuer deteriorates is highly unlikely. Zero interest rates would mean that investors are not receiving any return on their investment, which is not a realistic expectation in financial markets.
Even in the case of extremely low or negative interest rates, there would still be some level of return expected by investors.
D. None of these:
This option is incorrect because, as explained above, the market does expect a specific outcome when the credit quality of the issuer deteriorates. In this case, the market expects a higher rate of interest to compensate for the increased credit risk associated with investing in bonds or securities issued by entities with poor creditworthiness.
In conclusion, when the credit quality of the issuer deteriorates, the market expects a higher rate of interest. This is because investors demand higher returns to offset the increased risk of default associated with investing in lower credit quality securities.
The other options (lesser rate of interest, zero rate of interest, and none of these) are not correct because they do not align with the principles of risk and return in financial markets.