FRM Part I · FRM Exam Part I · Corporate Bonds
A corporate bond has an observed spread over the risk-free curve of 185 bps. Credit-default-swap-implied default compensation for the issuer is 140 bps, and the bond's liquidity premium is estimated as the remainder of the spread. A fund must sell a position whose market-impact cost is expected to widen the spread by a further 25 bps for the sale. What spread, in bps, should the fund expect to realize on the sale, and what is the liquidity premium before impact?
The liquidity premium is 45 bps (185 minus 140), and the expected sale spread is 210 bps. Market impact from a forced sale widens the spread by another 25 bps, which lowers the price received. Subtracting the impact would wrongly imply a higher price.
- ASale spread 210 bps; liquidity premium 45 bpsCorrect
- BSale spread 185 bps; liquidity premium 45 bps
- CSale spread 210 bps; liquidity premium 25 bps
- DSale spread 160 bps; liquidity premium 45 bps
Explanation
Liquidity premium = 185 - 140 = 45 bps. Selling pressure widens the spread by 25 bps, giving 185 + 25 = 210 bps, meaning a lower price. Using 160 subtracts the impact, the wrong sign.
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