A/An ________ in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

Question

BlackTom AI · Accepted Answer

To approach this question, we must assess how changes in liquidity affect bond prices and yields, holding other factors constant.
Option A: decrease; decrease; decrease. If liquidity decreases, trading becomes harder, which typically reduces price due to higher liquidity risk and higher yield to compensate investors. This option suggests prices and yields all fall together, which is inconsistent because a drop in liquidity usually increases the required return (yield) rather than decrease it. So this is incorrect.
Option B: decrease; increase; increase. Here, a drop in liquidity is paired with a higher price (decreased price would be expected, not increased) and higher yield. The combination contradicts the standard relationship that lower liquidity lowers price and raises yield, not increases price. Therefore, B is not correct.
Option C: increase; increase; decrease. When liquidity improves, bonds become easier to trade, which raises their price (lower liquidity risk premium). As price rises, the yield falls, since price and yield move inversely for a fixed cash flow. This option aligns with the conventional liquidity premium effect and is consistent with fundamental bond pricing.
Option D: increase; decrease; decrease. This option states that improved liquidity would raise price (okay) but also decrease yield, which would be the result of higher price, yet it lists both yield and price changes in a way that is internally inconsistent with the wording “increase; decrease; decrease.” The presence of two decreases after ‘increase’ does not match the standard inverse relationship between price and yield when liquidity improves. Hence D is incorrect.
In summary, the scenario described in option C—an increase in liquidity leading to higher price and lower yield—is the coherent and economically consistent choice.

A/An in the liquidity of corporate bonds will the price of corporate bonds and the yield on corporate bonds, all else equal.

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