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Return on Financial Assets - Math Problem Example

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Consider the following four debt securities, which are identical in every characteristic except as noted:  W: A corporate bond rated AAA  X: A corporate bond rate BBB  Y: A corporate bond rated AAA with a shorter time to maturity than bonds W and X  Z: A corporate bond rated AAA with the same time to maturity as bond Y that trades in a more liquid market than bonds W, X, or Y  1…
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Return on Financial Assets
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Download file to see previous pages tainty (low risk). In other words, invested money can earn higher profits only if there is a possibility of it being lost. Likewise, a corporate bond has several risks attached to it such as term to maturity risk, degree of liquidity risk and its credit rating. Each bond is discussed below with regard to the risk attached to it. I. Bond X will earn the highest return because of low credit rating which means that agencies regard this firm as highly risky. Moreover, it also involves maturity risk and degree of liquidity risk which is assumed as it is not stated. II. Bond W will earn a lower return in comparison to X but higher than Y and Z, as it is rated better by the rating agency which denotes low risk in terms of business operation. However maturity and liquidity risk exists which makes investor hesitant to take it unless it offers required return for it. III. Bond Y will yield more than Z but less than W and X because of its high credit rating, low term to maturity risk which is evident from the fact that investor will get his principal amount back before investor of bond W and X. But still it contains liquidity risk which will result in paying a higher return than bond Z. IV. Lastly, bond Z will yield the least amount of return as it does not have liquidity risk, maturity risk and neither low credit rating. Investors won’t demand high return as their investment is relatively safe. 2. Explain how an economist could use the slope of the yield curve to analyze the probability that a recession will occur and why the spread may matter.  Answer: Yield curve shows a relationship between yield and maturity of a debt instrument. Its slope has always been a good indicator of economic movements, as it can indicate where investor sentiments are heading. It indicates investors’ expectation of economy and interest rate. A sharply upward sloping, or steep yield curve, has often been an indication of an economic shift. Yield curve can indicate upcoming recession when it starts to invert. It occurs when long-term yields fall below short-term yields (Besley and Brigham, 2000). Under anomalies, if investors think that economy will slow down or decline in the future they will be satisfied with lower yield. Inverted yield curves also suggest that the market is expecting inflation to remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation. 3. One year ago, you bought a bond for $10,000. You received interest of $400 at the end of the year, as well as your $10,000 principal. If the inflation rate over the last year was five percent, calculate the real return. Show your work.  Answer: Real return of a security is calculated by discounting the interest earned and principal invested to (t=0) i.e. today and then finding percentage return of the investment. For the above given question, firstly, principal amount and interest earned is added to get $10,400 and then discounted at a rate of 5% ...Download file to see next pagesRead More
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