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FRM Part I · FRM Exam Part I · Corporate Bonds

During a market stress episode, dealers reduce their corporate bond inventories while many investors try to sell. Which outcome is most consistent with this situation?

Bid-ask spreads widen and selling pushes prices down more, so the illiquidity premium in corporate bond yields rises. With dealers cutting inventory, providing immediacy to sellers becomes more costly, so transaction costs increase rather than fall.

  1. ABid-ask spreads narrow because dealer balance sheets are less cluttered
  2. BBid-ask spreads widen and price impact of sales rises, increasing the illiquidity premium in yieldsCorrect
  3. CTrading volumes rise and transaction costs fall due to greater competition among dealers
  4. DCredit spreads fall because investors prefer corporate bonds to government bonds

Explanation

When dealers withdraw liquidity provision while selling pressure rises, immediacy becomes costly. Spreads widen and prices move against sellers, raising the liquidity premium embedded in yields. The other options describe improved liquidity or a flight into corporates, which contradicts the scenario.

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