MGT201 Financial Management GDB 2 Solution Fall 2013

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?

Solution: T-bill’s returns do not change with change in the economy activity level because treasury must redeem the bills at par regardless of the change in economy.

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

Solution: The T-bills are risk-free in the default risk sense because the return will be realized in all possible economic states. However, this return is composed of the real risk-free rate plus an inflation premium. Since there is uncertainty about inflation, it is unlikely that the realized real rate of return would equal the expected real risk free rate. 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, which means T-bills are exposed to reinvestment rate risk. So, we conclude that there are no truly risk free securities.

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

Solution: A’s returns move with the economy, because the firm’s sales will generally experience the same type of ups and downs as the economy. If the economy is booming, A will also boom.

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

Solution: B is considered by many investors to be a hedge against bad times and high inflation, so if the stock market crashes, investors in this stock should do relatively well. Stocks such as B’s are thus negatively correlated with the economy.