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MGT201- Financial Management Graded Discussion Board (GDB) # 2 Fall 2014 End Date January 29, 2014

Topic for Discussion: “Risk and Return”

GDB Question:

Assume that you are recently graduated with majors in finance, and you just want to invest Rs. 100,000 in a business at the end of year 1. You are interested to plan for a 1-year holding period. Further, you have got the following information from market about different investment alternatives, which is shown with their probabilities and associated outcomes.

Returns on Alternative Investments
Estimated Rate of Returns

Economy activity level    Probability  T-Bills     A         B       C       Market Return

Recession                          0.3       10.0% (22.0%) 28.0% 10.0%   (13.0%)

Normal                              0.4        10.0% 20.0 %    0.0    7.0%     15.0%

Boom                                0.3        10.0%  50.0%  (20.0%) 30.0%   43.0%

Expected returns

R* = ∑PiRi                          1.0        10.0%  16.4%    2.4%    14.8%   15%

Discuss the following:

a. Why T-bill’s returns do not change with change in the economy activity level?

b. “T-bills returns are the risk-free”, comment on the statement.

c. Why do A’s expected returns move with the economy? Explain with logical reasoning.

d. Why do B’s expected returns move counter to the economy? Explain with logical reasoning.

Important Instructions:

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Replies to This Discussion

ALi RAZA

Your last two points are not satisfying. Option "A" and "B" need to be explain independently .. not relative to T-Bills.

all the answers in this. where 

A = Alta Ind.'s 

B = Repo Men's____________________________

b.         1.   Why is the t-bill’s return independent of the state of the economy? Do t-bills promise a completely risk-free return?

 

Answer:    The 8 percent t-bill return does not depend on the state of the economy because the treasury must (and will) redeem the bills at par regardless of the state of the economy.

The t-bills are risk-free in the default risk sense because the 8 percent return will be realized in all possible economic states. However, remember that this return is composed of the real risk-free rate, say 3 percent, plus an inflation premium, say 5 percent.  Since there is uncertainty about inflation, it is unlikely that the realized real rate of return would equal the expected 3 percent.  For example, if inflation averaged 6 percent over the year, then the realized real return would only be 8% - 6% = 2%, not the expected 3%.  Thus, in terms of purchasing power, t-bills are not riskless.

Also, if you invested in a portfolio of T-bills, and rates then declined, your nominal income would fall; that is, t-bills are exposed to reinvestment rate risk.  So, we conclude that there are no truly risk‑free securities in the United States.  If the treasury sold inflation-indexed, tax-exempt bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.

 

b.         2.   Why are Alta Ind.’s returns expected to move with the economy whereas Repo Men’s are expected to move counter to the economy?

 

Answer:    Alta Industries’ returns move with, hence are positively correlated with, the economy, because the firm’s sales, and hence profits, will generally experience the same type of ups and downs as the economy.  If the economy is booming, so will Alta.  On the other hand, Repo Men is considered by many investors to be a hedge against both bad times and high inflation, so if the stock market crashes, investors in this stock should do relatively well.  Stocks such as Repo Men are thus negatively correlated with (move counter to) the economy. (note:  in actuality, it is almost impossible to find stocks that are expected to move counter to the economy.  Even Repo Men shares have positive (but low) correlation with the market.)

Don't copy Past

c. Why do A’s expected returns move with the economy? Explain with logical reasoning.

c)      A’s expected return move with the economy because this projects T-Bill is least risky and has highest estimated rate of return.

d. Why do B’s expected returns move counter to the economy? Explain with logical reasoning.

d)      B’s expected returns move counter to the economy because this projects T-Bills are lower estimated rate of return. Moreover in Pakistan T-Bills rate, varies from 7% to 12% per annum depending on the money market. Moreover as we know that every day example of investing in T-bills risk level low and return also low.

a)      Because T-bill is an investment with a certain rate of return no chance of default and the certainty generally comes from a supreme amount of confidence in the issuer (govt.) of the investment. That’s why T-bills return does not change with change in economy.

b)      Treasures like T-bills are considered to be risk free as they are backed by the (govt.) and they are so safe, the return on such assets are closely equal to current interest rate.

c)      A’s expected return moves with economy it is not only increasing or not only decreasing. But it varies and fluctuates as economic activity level fluctuates. Because its internal factors are strong that’s why external factors or macro factors effect on A’s expected return.

d)     B’s expected return not varies it goes on decreasing only. Because its internal factors are not too strong and external factors are strong. So internal factors effect on B’s expected return.   

 PLZ DON'T COPY  PASTE IT'S MY OWN... 

Rubab thank you

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