Question

a. Would the required rate of return be lower on an A rated bond or a BBB rated bond, and why?

b. What is the best measure of risk for an asset held in isolation and in portfolio?

c. Is the yield to maturity (YTM) on a bond an estimate or an actual rate of return on a bond? Explain.

d. If a stock has a beta measure of 0.75, discuss what this means.

Answer 1

Solution to A

All-else equal, an A rated bond's required rate of return will be lower compared to a BBB-rated bond. This is because, the A-rated bond will have a much lower credit risk compared to BBB-rated bond. However, a long-dated A-rated bond might have a higher required rate of return compared to a BBB-rated bond with a very short maturity, because of the higher interest rate risk associated with the former.

Solution to B

The best measure of risk for an asset held in isolation is Coefficient of variation. The best measure of risk for a multi-asset portfolio is beta.

Solution to C

Yield-to-maturity is the rate of return an investor would expect, if he holds the bond till the end of maturity. Theoretically speaking, yield-to-maturity is the discount rate at which the present value of the future cash flows of the bond (coupons and par value of the bond at maturity) is equal to the current bond price.

Solution to D

If a stock has a Beta of 0.75, it means that the stock has lower volatility compared to the market or an index. It means that if the index rises over given period of time, the stock will not rise as much as the market/index. On the other hand, if the market falls, the stock will not fall as much as the market/index.

For example, if the market rises 10%, the stock with a Beta of 0.75 is expected to rise only 0.75*10% or 7.5%. However, if the market falls by 10%, that stock is expected to fall only by 0.75*10% or 7.5%