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QUESTION 3: 4 POINTS (1) In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of def

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Answer #1

(1)

If there is an increase in risk of default for AIG, investor confidence on AIG will decrease, which will reduce the demand for AIG bonds, shifting its demand curve to left, decreasing both price and quantity of AIG bonds. As Bond price and interest rate are negatively related, lower bond price will increase interest rate of AIG bonds.

In following graph, D0 and S0 are initial demand and supply curve for AIG bonds, intersecting at point A with initial price P0 and quantity Q0. As demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower price P1 and lower quantity Q1.

3 9.

(2)

If injection of capital into AIG restores investor confidence on AIG, the investors will demand more AIG bonds, shifting AIG bond demand curve rightward, increasing price and quantity of AIG bonds. This may continue until initial equilibrium point A in above graph is obtained. As bond price and interest rate are negatively related, increase in AIG bond price will decrease interest rate of AIG bonds.

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