Podcast
Questions and Answers
What is an example of an illiquid investment?
What is an example of an illiquid investment?
- Stock in a major corporation
- Exchange-traded funds
- Government bonds
- A work of art (correct)
What must investors consider when investing in foreign securities?
What must investors consider when investing in foreign securities?
- The reputation of the investment bank
- Only the financial health of the foreign firm
- Liquidity risk and exchange rate risk (correct)
- Primarily the inflation rate in the U.S.
What is liquidity risk?
What is liquidity risk?
- The potential for economic recession
- The volatility of stock prices in the market
- The chance of a loss due to currency fluctuations
- The risk associated with investments that cannot be sold quickly (correct)
What does exchange rate risk involve?
What does exchange rate risk involve?
If a U.S. investor buys Japanese stock denominated in yen, what additional uncertainty must they consider?
If a U.S. investor buys Japanese stock denominated in yen, what additional uncertainty must they consider?
What is the effect of an increase in an asset's price in the local currency for a foreign investor?
What is the effect of an increase in an asset's price in the local currency for a foreign investor?
When securities are initially sold, they are sold in which market?
When securities are initially sold, they are sold in which market?
What is the heading for capital markets that deals with all subsequent transactions after the initial sale?
What is the heading for capital markets that deals with all subsequent transactions after the initial sale?
What is the expected rate of return for the first investment example?
What is the expected rate of return for the first investment example?
How many possible outcomes are there in the second investment example?
How many possible outcomes are there in the second investment example?
What characteristic distinguishes the investment from the first example from the one with 10 outcomes?
What characteristic distinguishes the investment from the first example from the one with 10 outcomes?
What is the main reason the 10-outcome investment is considered risky?
What is the main reason the 10-outcome investment is considered risky?
What mathematical operation is used to compute the expected rate of return for the 10 possible outcomes?
What mathematical operation is used to compute the expected rate of return for the 10 possible outcomes?
In the 10 possible outcomes example, what is the expected rate of return calculated as?
In the 10 possible outcomes example, what is the expected rate of return calculated as?
What provides a higher certainty of return in investment analysis?
What provides a higher certainty of return in investment analysis?
What would an investor experience by investing in the option with 10 possible outcomes?
What would an investor experience by investing in the option with 10 possible outcomes?
What was the percentage decrease in the value of the yen relative to the dollar during the specified period?
What was the percentage decrease in the value of the yen relative to the dollar during the specified period?
What would be the return to a U.S. investor if the yen had strengthened against the dollar?
What would be the return to a U.S. investor if the yen had strengthened against the dollar?
What is the main reason U.S. investors receive a lower rate of return than Japanese investors?
What is the main reason U.S. investors receive a lower rate of return than Japanese investors?
What can be added to required rates of return when investing in countries with unstable political or economic systems?
What can be added to required rates of return when investing in countries with unstable political or economic systems?
How does the volatility of exchange rates relate to the exchange rate risk premium?
How does the volatility of exchange rates relate to the exchange rate risk premium?
Which of the following events represents a high country risk?
Which of the following events represents a high country risk?
What is the impact of the recent earthquake and tsunami in Japan on global investors?
What is the impact of the recent earthquake and tsunami in Japan on global investors?
Why is the United States considered to have the smallest country risk in the world?
Why is the United States considered to have the smallest country risk in the world?
What was the Baa-Aaa yield spread in 2009?
What was the Baa-Aaa yield spread in 2009?
Which type of bond is considered to have the highest quality rating?
Which type of bond is considered to have the highest quality rating?
What does a basis point represent in percentage terms?
What does a basis point represent in percentage terms?
Which component is considered the starting point for assessing the required rate of return?
Which component is considered the starting point for assessing the required rate of return?
What trend can be observed in the yield of U.S. government 3-month Treasury bills from 2004 to 2009?
What trend can be observed in the yield of U.S. government 3-month Treasury bills from 2004 to 2009?
Which of the following years saw the highest yield for Baa corporate bonds?
Which of the following years saw the highest yield for Baa corporate bonds?
What is the difference in yield between U.S. government 10-year bonds and Baa corporate bonds in 2009?
What is the difference in yield between U.S. government 10-year bonds and Baa corporate bonds in 2009?
How does the rating of Baa corporate bonds compare to Aaa bonds in terms of default risk?
How does the rating of Baa corporate bonds compare to Aaa bonds in terms of default risk?
What does an increase in the market risk premium indicate regarding the slope of the security market line (SML)?
What does an increase in the market risk premium indicate regarding the slope of the security market line (SML)?
How does a change in yield spreads affect investor behavior towards risky assets?
How does a change in yield spreads affect investor behavior towards risky assets?
What happens to the required rate of return for investments on the original SML when the market risk premium increases?
What happens to the required rate of return for investments on the original SML when the market risk premium increases?
What effect does expected real growth in the economy have on the SML?
What effect does expected real growth in the economy have on the SML?
Which of the following factors does NOT cause a parallel shift of the SML?
Which of the following factors does NOT cause a parallel shift of the SML?
An increase in the expected rate of inflation will cause the SML to shift in which direction?
An increase in the expected rate of inflation will cause the SML to shift in which direction?
What is a primary consequence of an increase in credit risk premiums?
What is a primary consequence of an increase in credit risk premiums?
Intrinsic risk characteristics of a bond will do what when the SML's slope changes?
Intrinsic risk characteristics of a bond will do what when the SML's slope changes?
Study Notes
Expected Rate of Return Computation
- Expected rate of return (E(Ri)) can be calculated through the weighted average of possible outcomes.
- Example 1 calculated E(Ri) as 0.07, indicating moderate uncertainty in investment returns.
Investment Outcomes and Uncertainty
- A second investment with 10 possible outcomes, ranging from -40% to 50%, was analyzed.
- The calculated E(Ri) for this wider range of outcomes was 0.05, equating to the earlier example but revealing heightened uncertainty.
Yield Spread
- The Baa–Aaa spread indicates changes in yield over time, with 2007 showing 91 basis points and increasing to 198 basis points by 2009.
- Basis points measure yield differences, where one basis point equals 0.01 percent.
Bond Ratings
- Bonds are rated by agencies based on credit risk; Aaa denotes very low risk, while Baa marks generally high-quality bonds with potential default risks.
Promised Yield Trends
- Promised yields of various bond types fluctuated from 2004 to 2010, evidencing the changing risk landscape of investments.
- Treasury bills and corporate bonds (Aaa and Baa) show distinct yield trends that reflect market conditions and investor perceptions of risk.
Required Rate of Return Factors
- Required rates of return are influenced by the risk-free rate, liquidity, and credit risks.
- Illiquid assets (art, antiques, remote real estate) typically demand higher return expectations due to uncertainty in selling prices and timing.
Exchange Rate Risk
- Exchange rate risk arises when investments are denominated in foreign currencies, affecting return calculations depending on currency fluctuations.
- Example illustrated that a U.S. investor in Japanese stock faced a 4% return due to currency depreciation, despite a 14% return in yen.
Political and Economic Risk
- Country risk or political risk relates to potential returns being affected by political instability or economic changes.
- The U.S. possesses the lowest country risk globally, while recent upheavals in Libya, Syria, and Japan highlight instability in other regions.
Market Risk Premium Changes
- Changes in market conditions affect the slope of the Security Market Line (SML), indicating how required rates of return are influenced by shifts in economic growth or inflation expectations.
- An increase in market risk premium leads to higher required returns for all risky assets, regardless of their intrinsic risk characteristics.
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Description
This quiz covers the concepts of expected rate of return, investment outcomes, yield spreads, and bond ratings. It examines how these factors contribute to understanding investment risk and uncertainty in financial markets. Test your knowledge on these essential finance topics!
