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a. (12pts) Using the supply and demand for bonds and liquidity preference frameworks, show (graphs required)...

  1. a. (12pts) Using the supply and demand for bonds and liquidity preference frameworks, show (graphs required) how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks? Explain.

b. (8pts) Explain what might happen to risk premium on corporate bonds during business cycle expansions and during recessions.

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Answer #1

As per keynesian liquidity preference theories, an investor will demand more money or premium interest rate on bonds or long term maturities with higher riskiness as investor will demand liquidity for cash holdings. However beyond certain point where riskiness of bond rises but interest rates fail to rise further is called as liquidity trap.

Both classical and keynesian theory assumes equality of supply and demand in determining interest rates.

Risk premium on corporate bonds rises during business cycle recession and the risk premium reduces during business cycle expansion. This is so because during recession the investors appetite towards risk is high in liue of higher return probability as bonds make up safe investment and hence investors tend to make more money when other instruments show limited returns.

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