Question
component options 1: inflation premium, default risk premium, maturity risk premium, real rate of return
component options 2: default risk prem., maturity risk prem., inflation prem., nominal risk-free prem.
compinent 3: default risk prem., maturity risk prem., inflation prem., real rate of return
comoinent 4: default risk prem., maturity risk prem., inflation prem., nominal risk-free prem.
component 5: default risk prem., maturity risk prem., inflation prem., nominal risk-free prem.
Risk and return EXPERT OSA ost valuation processes applied to securities and investments require forecasts of an assets's future expected cash ows and expected returns. The potential for variability in these cash flows and returns creates risk, and, in general, he risk associated with a forecast of cash flows a year from now is likely to be vith a forecast of cash flows five years from now. Aa Aa than the risk associated less or more Since there is risk involved in forecasting future cash flows, financial decision makers often require a risk premium to compensate for the risk to which they may be exposed. Therefore, there is trade-off between risk and return that necessitates balancing the lowest possible risk and the highest possible return for the assumption of that risk. This relationship between risk and return is represented as: Required Rate of Return Risk-Free Rate of Return Risk Premium The required rate of return can be broken down further into several components such as the inflation premium, default risk premium, liquidity risk premium, and so on. Based on your understanding of the components of required rate of return, identify the determinants with each characteristic described in the following table: Characteristic Component This is the rate for a short-term riskless security when inflation is expected to be zero. It is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate. As interest rates rise, bond prices fali, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty This is the rate for a riskless security that is exposed to changes in inflation. This is the premium added to the risk-free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security's entire life. Consider the following case: James owns common stock of AAAZ Corp., and Victoria owns income bonds of the same company. Whose investment is more exposed to seniority risk? O Victoria's investment O James's investment
Explanation / Answer
1) Risk associated with a forecast of cash flows a year from now is likely to be less than the risk associated with a forecast of cash flows five years from now.
2) Component 1 : real rate of return
Component 2 : Default risk premium
Component 3 : Maturity risk premium
Component 4 : nominal risk free premium
Component 5 : inflation premium
3) James's Investment, i.e., investment in stocks.
In case of default, not everyone is paid off. Creditors are paid in order of their seniority and lien on the assets of the company. Stocks are paid off in the last when everyone else is paid. So, they will have the higher seniority risk.
