Question

inan those related- wntractual obliges Part Short Anewer-2 questions (25% ) Answer the quuestion in the space alotted. Be specific, but concise. Partal credit will thee given Risk and return for stock and bonds sset is b How do the risks of hese cash Sows compare to one another and why? Accordingly, how do the expected returns of stocks and bonds typicaly compare to one ancther? t re the cash flows associated for a stock, as compared to a bond? 2. Diversification What is diversification and how does it work? a. What type of risk is relevant for determining the riskiness of portiolios and what is this risk called? b. If an investor chooses not to hold a diversified portfolio, can he or she expect higher retums? C. tion um

Answer 1

1]

a]

The cash flows for a stock are the dividends, and the sale price of the stock whenever it is sold.

The cash flows of a bond are the interest payments, and the face value payable at bond maturity.

b]

The cash flows of a stock are more risky because :

• The dividends are paid at the discretion of the board/management. There is no certainty that dividends will be paid. On the other hand, the interest payments on a bond are mandatory to be paid.
• The bond redemption value is fixed at the time of issuing the bond. However, the sale price of the stock is highly uncertain as it is determined by the market.

c]

As the cash flows of a stock have higher risk than the cash flows of a bond, the expected return for stocks is higher since stock investors demand higher return for the higher risk.