Chartered Financial Analyst (CFA) Practice Exam Level 2

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What primarily influences the width of the credit spread?

The overall economic conditions and market liquidity
The bond issuer's credit rating only
The duration of the bond
Fixed interest rates only

The correct answer is: The overall economic conditions and market liquidity

The width of the credit spread is primarily influenced by overall economic conditions and market liquidity. In times of economic uncertainty or downturns, investors become more risk-averse, leading to wider credit spreads as they require a higher premium to compensate for the perceived risk of default from lower-rated issuers. Conversely, in stable or improving economic conditions, spreads tend to narrow as confidence returns. Market liquidity plays a significant role as well. If a bond market is illiquid, it may result in higher credit spreads because investors may demand a premium for the increased risk of not being able to sell the bond easily. In contrast, a more liquid market typically results in tighter spreads due to the ease of trading. While the bond issuer's credit rating is a critical factor, it is not the sole influencer of credit spreads and is often a reflection of broader economic conditions. The duration of the bond and fixed interest rates do affect pricing and market dynamics, but they do not directly dictate the credit spread's width as much as the economic landscape and liquidity conditions.