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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds.

  1. a. Would your portfolio be riskless? Explain.
  2. b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain.
  3. c. What is the least risky security you can think of? Explain.

a.

Summary Introduction

To explain: The possibility of the portfolio being riskless.

Portfolio:

The portfolio refers to a group of financial assets like bonds, stocks, and equivalents of cash. The portfolio is held by the investors and financial users. A portfolio is constructed according to the risk tolerance and the objectives of the company.

Answer
  • The given portfolio consists of $250,000 of long-term U.S. government bonds. The given portfolio cannot be riskless.
  • This is so because a portfolio contains some risk in context with the interest rate.
  • The interest rate goes up and down in the market and this condition will affect the value of the bonds. So, it is not possible for the portfolio to be riskless.
Explanation
  • The portfolio is a combination or a set of investments in form of bonds, assets and cash equivalents.
  • Any kind of investment contains some risk.
  • The factor of risk depends upon the rate of interest that fluctuates with the market conditions.
  • Hence, the idea of having a riskless portfolio does not work.
Conclusion

Thus, it is not possible for a portfolio to be riskless.

b.

Summary Introduction

To explain: The possibility of Treasury bill portfolio being riskless.

Answer
  • In the given situation, the portfolio consists of $250,000 in the form of Treasury bills. These bills have duration of 30 days after which they mature and they are again reinvested.
  • The person wants to live in the investment income from the portfolio by maintaining a constant standard of living. However, this condition is not possible as this portfolio again contains risk.
  • The inflation rate is higher than the interest rate. In this case, the investor will get the purchasing power and by the result of which his standard of living can decline.
  • However, they contain less risk as treasury bills are backed by the U.S. government.
Explanation
  • The treasury bills are the short-term U.S. government securities which do not give interest but is issued at a discounted price.
  • In the given case, the portfolio is of treasury bills, which once matured is again reinvested.
  • By the investment income, the person has to maintain a constant standard of living. This is not possible because treasury bills also contain some risk.
  • However, the treasury bills are those kinds of securities which are backed by the government, so they contain a minimum risk or can be considered as riskless.
Conclusion

The treasury bills portfolio can also be not truly riskless.

c.

Summary Introduction

To explain: The possible least risky security.

Answer
  • There is no security which is totally riskless.
  • But some securities can be closest to no risk situation which is Treasury inflation-protected securities.
  • As these securities are guaranteed by the U.S. government and their return is adjusted to compensate for the inflation, so these are somewhat riskless.
Explanation
  • The securities always contain some risk in it. There are many factors which effect the security or the stock.
  • These are the interest rates and the inflation rates.
  • There is no such security which is considered to be riskless.
  • However, the treasury bills are backed by the U.S. government, so these are less risky.
  • The treasury inflation protected securities are protected by the inflation effect and so are considered to be almost least risky security.
Conclusion

Thus, the Treasury inflation-protected securities are the least risky security.

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