Understanding Credit Risk: A Classroom Experiment

Abstract

This classroom experiment introduces students to the notion of credit risk and expected return, by allowing them to trade on comparable corporate bond issues from two types of markets - investment-grade and high-yield. Investment-grade issues have a lower probability of default than high-yield issues, and thus provide a lower yield. There are three ways in which participants can earn money - from coupon payments, the face value of the bond, and by capital gains. While participating in an experiment, students learn about the notion of risk and return, how credit risk affects bond prices, the movement of bond prices through time, as well as other general characteristics of the bond markets.

Keywords: Teaching experiment, credit risk, bond market, risk and return

JEL Classification: A20, C90, D84