Question

When the economic outlook improves, the probability of bankruptcy decreases. Use the loanable funds theory with the appropriate supply and demand diagrams to explain what happens to the size of the risk premium between the corporate and the Treasury bonds.  

Answer 1

(a) Loanable funds theory

Lower probability of bankruptcy will encourage firms to investment more. This will increase the demand for loanable funds, shifting its demand curve rightward and increasing both interest rate and quantity of loanable funds.

In following graph, D0 and S0 are initial demand and supply curves for loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds Q0. Higher demand shifts D0 rightward to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds Q1.

(b) Demand and Supply model

When probability of default decreases, corporate bonds become more attractive to investors, so they demand more corporate bonds and less treasury bonds. Demand curve for corporate bonds shifts rightward, increasing its price and quantity. Demand curve for treasury bonds shifts leftward, decreasing its price and quantity.

In each graph, D0 & S0 are initial bond demand and supply curves intersecting at point A with initial price P0 and quantity Q0. For corporate bonds, as demand increases, D0 shifts right to D1, intersecting S0 at point B with higher price P1 and higher quantity Q1. For treasury bonds, as demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower price P1 and lower quantity Q1.

Interest rate is inversely related to bond price. So, in corporate bond market, higher bond price will decrease interest rate. In treasury bond market, lower bond price will increase interest rate. As a result, risk premium between corporate bonds and treasury bonds (= Corporate bond interest rate - Treasury bond interest rate) will decrease.

(i) Corporate bond sector

(ii) Treasury bond sector