Finance Chapter: Expected Returns and Risk

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Questions and Answers

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?

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?

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?

The uncertainty of returns when converting currencies Signup and view all the answers

If a U.S. investor buys Japanese stock denominated in yen, what additional uncertainty must they consider?

Changes in the exchange value of yen to U.S. dollars Signup and view all the answers

What is the effect of an increase in an asset's price in the local currency for a foreign investor?

It may not result in a gain when considering currency exchange rates Signup and view all the answers

When securities are initially sold, they are sold in which market?

Primary market Signup and view all the answers

What is the heading for capital markets that deals with all subsequent transactions after the initial sale?

Secondary market Signup and view all the answers

What is the expected rate of return for the first investment example?

$0.07$ Signup and view all the answers

How many possible outcomes are there in the second investment example?

10 Signup and view all the answers

What characteristic distinguishes the investment from the first example from the one with 10 outcomes?

Less uncertainty about returns Signup and view all the answers

What is the main reason the 10-outcome investment is considered risky?

There is a wide range of possible outcomes. Signup and view all the answers

What mathematical operation is used to compute the expected rate of return for the 10 possible outcomes?

Summation of weighted returns Signup and view all the answers

In the 10 possible outcomes example, what is the expected rate of return calculated as?

$0.05$ Signup and view all the answers

What provides a higher certainty of return in investment analysis?

An investment with a single return Signup and view all the answers

What would an investor experience by investing in the option with 10 possible outcomes?

High uncertainty about returns Signup and view all the answers

What was the percentage decrease in the value of the yen relative to the dollar during the specified period?

9.5% Signup and view all the answers

What would be the return to a U.S. investor if the yen had strengthened against the dollar?

14 percent Signup and view all the answers

What is the main reason U.S. investors receive a lower rate of return than Japanese investors?

Exchange rate risk Signup and view all the answers

What can be added to required rates of return when investing in countries with unstable political or economic systems?

Country risk premium Signup and view all the answers

How does the volatility of exchange rates relate to the exchange rate risk premium?

Higher volatility increases the risk premium. Signup and view all the answers

Which of the following events represents a high country risk?

A deadly rebellion against a government Signup and view all the answers

What is the impact of the recent earthquake and tsunami in Japan on global investors?

Greater uncertainty regarding global markets Signup and view all the answers

Why is the United States considered to have the smallest country risk in the world?

Stability of its political and economic systems Signup and view all the answers

What was the Baa-Aaa yield spread in 2009?

198 basis points Signup and view all the answers

Which type of bond is considered to have the highest quality rating?

Aaa corporate bonds Signup and view all the answers

What does a basis point represent in percentage terms?

0.01 percent Signup and view all the answers

Which component is considered the starting point for assessing the required rate of return?

The risk-free rate Signup and view all the answers

What trend can be observed in the yield of U.S. government 3-month Treasury bills from 2004 to 2009?

The yield decreased significantly after 2007. Signup and view all the answers

Which of the following years saw the highest yield for Baa corporate bonds?

2008 Signup and view all the answers

What is the difference in yield between U.S. government 10-year bonds and Baa corporate bonds in 2009?

2.03% Signup and view all the answers

How does the rating of Baa corporate bonds compare to Aaa bonds in terms of default risk?

Baa bonds have some possibility of default under adverse economic conditions. Signup and view all the answers

What does an increase in the market risk premium indicate regarding the slope of the security market line (SML)?

The slope of the SML increases. Signup and view all the answers

How does a change in yield spreads affect investor behavior towards risky assets?

Investors require higher yields for riskier assets. Signup and view all the answers

What happens to the required rate of return for investments on the original SML when the market risk premium increases?

It increases for all investments. Signup and view all the answers

What effect does expected real growth in the economy have on the SML?

It causes a parallel upward shift. Signup and view all the answers

Which of the following factors does NOT cause a parallel shift of the SML?

Changes in investor sentiment. Signup and view all the answers

An increase in the expected rate of inflation will cause the SML to shift in which direction?

Upward shift. Signup and view all the answers

What is a primary consequence of an increase in credit risk premiums?

Change in the slope of the SML. Signup and view all the answers

Intrinsic risk characteristics of a bond will do what when the SML's slope changes?

Remain unchanged. Signup and view all the answers

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!