FIN 571 Week 2 - DQ 1 - 7638

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Assume that the Federal Reserve unexpectedly raises interest rates. As a result, bond prices and stock prices both fall. What explanation can you give for this?

 

What is interest-rate risk? How is interest-rate risk related to the maturity of a bond and to the coupon rate for a bond?

I believe the Federal Reserve would increase interest rates to fight inflation. This sudden change can make bond prices and stock prices to fall. This may be an effort to jumpstart the economy but they have to be careful because this change can make it difficult to create new jobs sometimes.

An interest rate risk according to (Investor Words), is “the possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.”

 Now that we now that interest rate risk is “the risk of a change in the value of a bond because of a change in the interest rate, (Emery, Finnerty & Stowe, 2007).”  Bonds with higher coupon rate tend to have lower interest rate risk because of its higher default risk. The coupon rate for a bond is where the expected return comes from but it does not affect the interest rate changes. Some people say that the longer the bond takes to mature the bigger the interest rate risk.

 

 

Reference:

Emery, Finnerty,; Stowe. (2007). Corporate Financial Management(3rd ed.). New Jersey: Pearson-Prentice Hall.

interest rate risk. InvestorWords.com. Retrieved May 04, 2010, from InvestorWords.com website: http://www.investorwords.com/2546/interest_rate_risk.html

 

 

 

1.       Suppose you own $1 million worth of 30-year Treasury bonds. Is this asset riskless?

As we all know there is no such thing as assets that are risk free or riskless. The problem is that the risk for inflation will always be there, this is why we can say there is not too much control of what can happen with those assets. If we consider interest rate risks the best thing to do is sell those assets before they mature to mitigate the risk. On the good side treasury bonds risk is very low compared to interest rates.

 

2.      You own $1 million worth of 90-day Treasury bills. You “roll over” this investment every 90 days by reinvesting the proceeds in another issue of 90-day Treasury bills. Is this investment riskless?

As I mentioned before, investments are not 100% risk free. Interest rates on treasury bills are taxable incomes reducing the return at the same time. A big risk we see in most investments is inflation. It depends on the percentage of the inflation but no inflation is going to be 0% because otherwise there wouldn’t be a need to say we were going through an inflation process. The problem with taxes and inflation is that they will lead us to purchasing power risk and devaluate our investment over time. For example we might invest “x” amount today and over a year we may have “y” amount losing a good considerable amount of money.

 

3.      Can you think of an asset that is truly riskless?

I cannot think of an asset that is completely riskless. This is due the reality that even governments can fall, this can cause some currencies to even lose its current value leading to monetary devaluation and finally some markets may even cease to exist or to be interesting or profitable enough to invest in.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

What is the difference between diversifiable risk and nondiversifiable risk? Describe the CAPM

Diversifiable risk is the risk which can be mitigated by investing in different companies, different sectors, different assets and different regions.  This tries to minimize the risk of loss by taking the risk against one or few companies, sectors, assets, and regions.

 

Non-Diversifiable risk cannot be mitigated. This is the risk we get exposed to in individual investment. No matter how many stocks we buy we will always have this risk.

 

According to (Investor Words), “capital asset price model (CAPM) is an economic model for valuing stocks by relating risk and expected return. Based on the idea that investors demand additional expected return which is called the risk premium if asked to accept additional risk.”

With this definition we can deduct the following: all investors can expect the same returns for the same assets, all investors have access to the same information, no taxes nor transaction costs and that the markets are in equilibrium: no arbitrage opportunities.

 

These assumptions say that the capital asset price model (CAPM) claims that an investor’s expected rate of return is the rate of return of a risk-free asset plus the market risk premium correlated to the measurement of market risk.

 

Reference:

CAPM. InvestorWords.com. Retrieved May 04, 2010, from InvestorWords.com website: http://www.investorwords.com/735/CAPM.html

Investopedia.com (2010) Diversifiable Risk. Retrieved May 4, 2010 from www.investopedia.com

Investopedia.com (2010) Non-Diversifiable Risk. Retrieved May 4, 2010 from www.investopedia.com

Solution Description

Assume that the Federal Reserve unexpectedly raises interest rates. As a result, bond prices and stock prices both fall. What explanation can you give for this?

 

What is interest-rate risk? How is interest-rate risk related to the maturity of a bond and to the coupon rate for a bond?

I believe the Federal Reserve would increase interest rates to fight inflation. This sudden change can make bond prices and stock prices to fall. This may be an effort to jumpstart the economy but they have to be careful because this change can make it difficult to create new jobs sometimes.

An interest rate risk according to (Investor Words), is “the possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.”