If a corporation begins to suffer large losses, then the default risk on its bond will:

Question

BlackTom AI · Accepted Answer

Default probability rises when a firm records large losses, so the bond’s default risk increases — this raises uncertainty about future cash flows and lowers the bond’s expected return.

1) Relevant concepts
- Default risk (probability the issuer fails to make promised payments) directly affects expected cash flows to bondholders and the volatility (uncertainty) of those cash flows.
- Expected return = expected cash flow / price (or expected payoff relative to initial investment). If the probability of default increases, the expected payoff falls unless offset by higher recovery or higher coupon.
- Distinguish expected return (the statistical expectation of payoffs) from the required yield investors demand; losses increase default risk and uncertainty and typically reduce expected payoff.

2) Step-by-step reasoning
- Large corporate losses reduce the issuer’s ability to meet interest/principal, so the probability of default (PD) rises.
- A higher PD means some scenarios will produce reduced or zero payments; therefore the distribution of possible returns becomes wider (more uncertain).
- Because some future cash flows are now less likely, the expected (probability-weighted) payoff to existing bondholders falls.

3) Numerical illustration (intermediate steps)
- Pre-loss: suppose bond pays 105 in one year (100 principal + 5 coupon). Assume PD = 1% and recovery in default = 40.
  Expected payoff = 0.99*105 + 0.01*40 = 103.95 + 0.4 = 104.35.
- Post-loss: PD rises to 6% (same recovery 40).
  Expected payoff = 0.94*105 + 0.06*40 = 98.7 + 2.4 = 101.1.
- Expected payoff fell from 104.35 to 101.1, showing lower expected return and higher payoff variance.

4) Why the correct answer is correct
- Option b states default risk increases, returns become more uncertain, lowering expected return — exactly the logical consequence of higher PD and the numerical example above.

5) Why other options are incorrect
- a and c claim default risk decreases — inconsistent with the firm suffering losses.
- d says returns become less uncertain despite increased default risk; that contradicts the increased variability caused by a higher probability of default.

Conclusion: The correct choice is b. This matches the provided answer: "b. increase and returns become more uncertain, lowering expected return."

If a corporation begins to suffer large losses, then the default risk on its bond will:Single choice

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