Risk and Term Structure of Interest Rates

6. Do bonds reduce the overall risk of an investment portfolio? Let x be a random variable representing annual percent return for the Vanguard Total Stock Index (all Stocks). Let y be a random variable representing annual return for the Vanguard Balanced Index (60% stock and 40% bond). For the past several years, assume the following data. Compute .

The concept does not rely on the actual existence of such an interest rate, so A and C are false. By definition, it is a constant so B is false. 4. Which of the following statements about bonds is true? a) A zero-coupon

For example, stocks traditionally have a potential for higher return than bonds over time because stocks are usually a riskier investment than bonds.

Within these two categories there are different options in regards to risk and return levels, both of which run parallel to each other meaning the higher the risk the higher the rate of return. The below graph (Figure 3) shows the average one year return for each of the investment strategies.

3. What factors will contribute to the riskiness of these bonds? Explain in detail your rationale.

1. Distinguish between pure risk and speculative risk. List and explain in detail the three kinds of pure risk.

The risk of a large price drop if the bond must be sold quickly or the inability to sell quickly without incurring a large price drop.

Preferred stock has a preferred position in the claim on the income flow of the firms. Preferred stock dividends, usually a fixed rate relative to par value, are paid ahead of common stock dividends. The dividends of preferred stocks are different from and generally greater than those of common stock. Corporate bonds are debt instruments created by companies for the purpose of raising capital. They are called fixed-income securities because they pay a specified amount of interest on a regular basis. Preferred and Common stocks have three major risk factors: 1) dividend suspension or company failure, 2) rising interest rates, 3) low trading volumes. Most corporate bonds are debentures, meaning they are not secured by collateral. Investors of such bonds must assume not only interest rate risk but also credit risk; they chance that the corporate issuer will default on its debt

a liability for the face amount of the bonds and paid-in capital for the premium over the face amount.

a. What risk-free rate and risk premium did you use to calculate the cost of equity?

If the company benefits from the provision of the bond, then the coupon rate will be higher. If the bondholder’s benefit, then the bond will have lower coupon rate.

It provides an evaluation of the bond issuer’s financial strength and ability to pay back the bond’s principle and interest. The bond rating also provides investors with some sense of security when investing in a particular firm. A higher bond rating implies a lower likelihood for the firm to default. Investors would feel more secured investing in such a bond, thus demanding a relatively lower rate of return. As such, high rated bonds enable the issuer to enjoy a lower cost of borrowing. A lower bond rating, on the other hand, serves as a negative signal to investors on the firm’s ability to repay debt obligations.

To better determine if an arbitrage opportunity exists, the theoretical and actual yield spreads of both bonds can be compared. This determines whether both bonds are properly priced relative to each other, eliminating the need to have true prices for both bonds to determine if each bond is rightly priced. Based on our

Though bonds provide such safety, their yields are very low and have little potential for capital appreciation in the long-run for both the issuer and receiver. Besides, the low interest-rate of bonds makes the return on holding cash virtually non-existent (Voya & Scotia, 2009). Convertible bonds, however, offer a middle ground between the safety of bonds and the upside potential, and risk, of stocks. For this firm seeking income, higher-yielding convertibles bonds are the right options they can explore. This allows for the downside protection of a

Interest Rate Risk - In the process of FIs performing their asset-transformation function, FIs are exposed to Interest Rate Risk, from Mismatched Maturity/Duration: Borrowing Short, Lending Long.  The risk that an investment 's value will change due to a change in the absolute level of interest rates, in the