Question

Risk premiums on corporate bonds are usually countercyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Answer 1

Answer - The risk premiums can be called as the extra returns which is given to the security holder for the additional risk that he takes. In the period of expansion , the economy is doing well , income is increasing and hence the risk in the investment is less. Hence the risk premium is reduced. In the period of recession , the economy is going down , interest rates rise , prices fall , incomes reduce. This brings up the greater risk to people who invest. Hence in the time of recession , the risk premiums are higher as a reward for taking the high risk.