1.

Explain the following statement: The potential return on any

investment should be directly related to the risk the investor assumes.
As an investor, it is desirable to invest in a product that is favourably
proportional to the risk that it possesses, which that it would fall on the
SML line. However, in reference to the statement, the great majority of
investments available do not fall on the SML line.
The risk that an investment inherits can be understood further by
analysing the types of risk that an investment has Systematic
(uncontrollable, dependent on market circumstances) and Idiosyncratic
(firm/investment specific) risk.
For example, a share of a company and an index fund with identical
returns will have vastly different risks. Consider this: if any particular ASX
share has an expected return of 10% and a diverse index fund has a
return of 10%, the share is likely to have a far greater risk than that of the
index fund, as it is susceptible to both idiosyncratic and systematic risk,
and is therefore prone to wild price swings. This means it is a riskier
product, as risk and variance are synonymous in the world of finance.
However, this is not the case with the Index fund investment. Because of
the diversification of the index fund, its idiosyncratic risk is negligible, and
is therefore only susceptible to systematic risk. This means that it will on
average be prone to significantly less price swings and therefore has a
lower variance, and is therefore a less risky investment product.
Therefore, the potential return on any particular investment shouldnt
always be directly related to the risk of the investment, as this would
require idiosyncratic risk to be non-existent which is simply unfeasible in
the modern day corporate world.
Another point to consider is that there are often undervalued stocks,
which can potentially be identified by investors and profited from. These
investments often sit above the SML and therefore the return is not
directly related to the risk assumes, rather the return is disproportionally
higher. However, according to semi strong market form efficiency, such
stock prices should not exist, and therefore aligns with the statement that
the return on an investment should be directly related to the systematic
risk it assumes, but it does not hold true for idiosyncratic risk.
However, if you are an investor making an investment decisions, you
should be investing in investments that are directly related to the risk the
investor assumes. As shown above, it is possible to invest in products
where the returns are not directly related to the risk, but from a risk
return point of view, it is advantageous for an investor to choose a less
risky investment with the same returns, and it is a commonly held view
that the best investments are those that fall on the SML, thus

demonstrating that the best investments are directly relate to the risk
they assume.
2. Assume that you are choosing an investment for your retired parents.
Would you choose a bond issued by the federal government, a state or
local government, or a corporation? Justify your answer.
If you are looking to choose an investment for a retiree, a product with
that minimises risk is likely to be the most desirable option, as the retirees
are looking to increase their net wealth at a reasonable rate as the funds
are likely to be used in the short term and the risk of losing a great portion
of their net wealth through riskier investments is undesirable.
Federal government issued bonds are often the safest option of the 4,
depending on the country. In Australia, for example, the federal
government has a long standing AAA rating, however in recent times
Standard & Poors has warned Australia about its budget and the potential
to be downgraded to a AA rating. However, there are less than 20
countries worldwide with a AAA rating.
Another alternative, State government bonds, are a good option for a
retiree. The NSW governments credit is rated AAA by both Moodys and
S&P, implying a 0% historical risk for investors in NSW government bonds.
However other state governments have a weaker credit rating, such as
WA, who have a credit rating of AA+ and AA2 with S&P and Moodys
respectively.
The other alternative is the Corporate Bonds. Corporate bonds
traditionally have a slightly higher return as a result of their slightly higher
risk for highly rated bonds. Historically, AAA rated corporate bonds come
with a 0.6% default risk, with lower rated bonds having substantially
higher risks
If I was choosing a bond for my retired parents, I would choose a federal
government AAA bond, marginally over a State government AAA rated
bond. The logic behind this decision can be understood when considering
that risk minimisation is the highest priority, as discussed earlier.
Traditionally, federal governments are less prone to credit rating swings
due to idiosyncratic risk, which is arguably to blame for WAs downgrading
of their credit rating, with factors such as state specific GST issues and the
slowing of the mining boom seen as reasons for the rating drop by many.
The increase risk of the highest rated corporate bonds puts it marginally
behind that of the state and government bonds, however, the AAA
corporate bonds are still quite a good option. Local government bonds are
also a solid alterative, however they are prone to more idiosyncratic risk
than that of the state and government bonds, and are therefore closer to
that of the corporate bonds in terms of risk.

3. In what circumstances would a $1,000 corporate bond be worth more

than $1,000? In what circumstances would the corporate bond be worth
less than $1,000?
Corporate bonds are worth more than the $1000 face value when the
current interest rate is less than that of the coupon rate, with at least one
coupon payment remaining before maturity.
This is because the present value of the future coupon payments is larger
than the gap between the present and future value of the $1000 bond at
maturity (due to the time value of money) as shown in the example below

Example 1: 2 year bond, face value of $100. Coupon rate is 10%/annum,

with semi-annual coupons. The Interest rate is 8%/annum, which is lower
than that of the coupon rate.

As discussed above, the NPV of the coupon payments ($18.14) is greater

than that of the difference between the bonds face value and the market
rate ($100-$85.48 = $14.52). This is due to the fact that coupon rate is
higher than that of the interest rate, and is how bonds with higher market
values than face values are derived.
If for example, the interest rate and the coupon rate were identical, the
market value would be the same as the Bonds face value.
If the current interest rate is higher than that of the coupon rate, the
market value of the bond would be less than that of the face value. This is
directly opposite to that of the first example, as in this scenario, the NPV
(net present value) of the coupon payments is less than the gap between
the market value and the face value.
4. You are considering two different corporate bonds. One is rated AAA
by Standard & Poors and pays 5.8 percent annual interest. The other
bond is rated B by Standard & Poors and pays 7.5 percent annual
interest. What do these ratings mean? Which bond would you choose
and why?

By Definition, the S&P rated AAA bond means it is a bond that is judged to
be of the best quality. Because of the high quality nature of the bond, it is
deemed to be low risk (where high risk would be the institute issuing the
bond is at risk of defaulting) and therefore the return is close to that of the
interest rate at 5.8%
By Definition, the S&P rated B bond is a bond that generally lacks
characteristics of the desirable investment and are subject to high credit
risk. Because of this high credit risk the bond has a much higher return at
7.5%
In terms of the bond that I would choose, there are a number of factors
that have to be considered. Firstly my personal situation. I am a student
and my current investments are geared towards the very long term.
Because of that, my investments tend to be geared towards riskier
investments, as long as the rewards is worth the increase in risk.
Secondly, the risk and relative reward of the bonds needs to be
considered. Traditionally, the lower rated bonds tend to have a much
higher return increase (compared to the AAA bond) relative to the
increase in risk for a variety of reasons firstly, there is a large group of
customers who will tend towards the AAA bonds, regardless of the returns
of the riskier bonds because of their personal circumstances where they
are looking for a safe, short term return. If the increase in return is
proportional to the risk, then the AAA bonds will still be both a better short
and long term investment, as the geometric average return in the long run
would be less than that of the geometric return of the AAA bond (in nearly
all investment strategies). Therefore, the providers of the bonds look to
make the B & other riskier bonds appealing for investors by providing
higher returns proportional to the associated risk.
According to historical data, A S&P rated B Bond has an 8.48% chance of
defaulting if it is a Municipal bond and a 53.72% chance of defaulting if it
is a Corporate Bond. In comparison, historical figures show that an S&P
rated AAA bond has a 0% chance of defaulting if it is a municipal bond
and a 0.6% chance if it is a corporate bond.
Although the wording of the question does not specify, one would assume
that it is a Municipal bond on offer. If this is the case, the B level Bond is
likely to have a greater NPV than that of the AAA bond, depending on
other unspecified variables, which is east to see once you consider the
approximately 29% increase in returns and an approximately 8% increase
in risk. For this reason and others stated above, I would be more likely to
invest in the B rated bond.
However, if it was a corporate bond, the increase in risk would far
outweigh the increase in return and I would invest in the AAA bond on
offer.