A high current yield with credit and liquidity risk
Series X-A case study · set 3, case 3 of 9 · 5 questions · 1 mark each
Question 1 of 5Case practice
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A fictional corporate bond has face value ₹1,000, an annual coupon of ₹70 and market price ₹880. The unusually low price reflects investor concern about the issuer’s repayment capacity and thin trading. For one scenario, the holder receives the ₹70 coupon and sells one year later for ₹800. For a separate default scenario, assume no coupon is paid and the final recovery is 40% of face value. These scenarios are alternatives. Tara needs her investment money in three months, but the dealer warns that a buyer may not be available then. No rating, price or recovery in this case is a current market quotation.
All people, firms, prices and contract terms are fictional.
Ignore taxes and transaction costs unless the case explicitly includes them.
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The case and its answers
Every question of this case, with its answer and why each other option is wrong.
A fictional corporate bond has face value ₹1,000, an annual coupon of ₹70 and market price ₹880. The unusually low price reflects investor concern about the issuer’s repayment capacity and thin trading. For one scenario, the holder receives the ₹70 coupon and sells one year later for ₹800. For a separate default scenario, assume no coupon is paid and the final recovery is 40% of face value. These scenarios are alternatives. Tara needs her investment money in three months, but the dealer warns that a buyer may not be available then. No rating, price or recovery in this case is a current market quotation.
All people, firms, prices and contract terms are fictional.
Ignore taxes and transaction costs unless the case explicitly includes them.
Q1What is current yield at the ₹880 purchase price, to two decimals?
Option A. 7.00%
Why it is wrong: This is the coupon rate based on face value.
Option B. 40.00%
Why it is wrong: This is the separate recovery assumption.
Option C. 12.00%
Why it is wrong: This is the discount to face value as a percentage of face value.
Option D. 7.95% — Correct answer
Answer: D. ₹70 ÷ ₹880 × 100 = 7.95%. This does not measure default-adjusted total return. Remember: A high current yield can coexist with substantial credit risk.
Hint, shown before you answer in practice mode: Divide annual coupon by purchase price.
XA-S3-C03-Q1mediumnumerical
Q2In the coupon-and-sale scenario, what is the one-year total return?
Option A. 7.95%
Why it is wrong: This ignores the ₹80 capital loss.
Option B. 9.09%
Why it is wrong: This treats the price decline as a gain.
Option C. −1.14% — Correct answer
Option D. −9.09%
Why it is wrong: This ignores the coupon received.
Answer: C. (₹800 − ₹880 + ₹70) ÷ ₹880 × 100 = −1.14%, rounded. Remember: Coupon income does not guarantee a positive holding-period return.
Hint, shown before you answer in practice mode: Add the coupon to the price change before dividing by cost.
XA-S3-C03-Q2mediumnumerical
Q3In the separate default scenario, what cash is recovered per bond?
Option A. ₹880
Why it is wrong: This assumes full recovery of cost.
Option B. ₹470
Why it is wrong: This adds a coupon that the scenario says is not paid.
Option C. ₹400 — Correct answer
Option D. ₹352
Why it is wrong: This applies recovery to purchase price instead of face value.
Answer: C. 40% × ₹1,000 = ₹400. Remember: Recovery assumptions must specify the amount to which the percentage applies.
Hint, shown before you answer in practice mode: The recovery base is explicitly face value.
XA-S3-C03-Q3mediumnumerical
Q4What is the loss relative to the ₹880 purchase price in that default scenario?
Option A. ₹528
Why it is wrong: This assumes a 60% loss on purchase cost.
Option B. ₹410
Why it is wrong: This incorrectly adds the unpaid coupon to recovery.
Option C. ₹480 — Correct answer
Option D. ₹600
Why it is wrong: This compares recovery with face value instead of purchase cost.
Answer: C. ₹880 − ₹400 = ₹480. Remember: An investor’s rupee loss depends on what was paid and what is recovered.
Hint, shown before you answer in practice mode: Compare the actual investment cost with the final recovery.
XA-S3-C03-Q4mediumnumerical
Q5Which case fact most directly makes this bond unsuitable for relying on a three-month cash exit?
Option A. The coupon is quoted annually.
Why it is wrong: Coupon frequency alone does not establish whether a resale is available.
Option B. Thin trading may prevent a sale when Tara needs the money. — Correct answer
Option C. Current yield exceeds the coupon rate.
Why it is wrong: That arithmetic relationship alone does not ensure or prevent a sale.
Option D. Face value is a round number.
Why it is wrong: The denomination does not determine liquidity.
Answer: B. The dealer’s warning means Tara cannot rely on obtaining a buyer in three months. Credit risk is an additional concern, separate from liquidity. Remember: A dated cash need requires attention to marketability, not just yield.
Hint, shown before you answer in practice mode: Focus on whether the required exit can be executed.
XA-S3-C03-Q5mediumapplication
Two purchases at different mutual fund NAVs
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