Topic 3 Required rate of return â is the rate of return that investors
Topic 3 Required rate of return – is the rate of return that investors require to compensate them for the risk associated with an investment. Expected return – will not necessarily equal the required rate of return, it can be lower, in which case the return will not be sufficient to compensate the investor for the risk associated with the investment if the expected return is realised. Risk Return Relationship o Positive Relationship. That means, an asset which has a higher risk is required/expected to give a higher return, and vice versa. This is generally true. However the expected return may not be materialized. o Equity security riskier than debt securities, shares do not have a promise of interest payments or repayment of principal. Shares do not have a maturity date. Shareholders have only the last claim on assets in the event of liquidation. Unique and Systematic Risks o Unique risk (unsystematic) risks = the risks arising or pertaining to the particular share (example, BHP shares); risks of it’s investments, sales, cost, management, industrial relations. These risks can be diversified by having a portfolio of different shares o System risks: The risks arising from market-‐wide factors: e.g., inflation, interest rate, foreign exchange rate, terrorist attacks. These risks cannot be diversified.
Topic 4 Bonds Valuation – Par, Premium and Discount Bonds o If a bond’s coupon rate is equal to the market rate, bond will sell at a price equal to its face value; these are called par bonds (I = C) o If a bond’s coupon rate is less than market rate, then bond will sell at a price less than its face value; these are called discount bonds (I > C) o If a bond’s coupon rate is greater than market rate, then bond will sell at price more than its face value; these are called premium bonds (I < C) Interest rate risk o If market interest rates are expected to increase in the future, portfolio managers (finance managers) should avoid investing in long term debt securities (e.g., bonds) now. (Longer term bonds experience a larger decline than shorter-‐term bonds.) • Portfolio could see significant decline in value o If you are an investor and you expect interest rates to decline, you will want to invest in long-‐term bonds now. • As interest rates decline, price of long-‐term bonds will increase more than price of a short-‐term bond. Explanation of negatively related relationship bonds prices and Interest rates o Bond prices and market interest rates are negatively related because, despite the change in the market rate, the coupon rate is constant over the life of the bond. I.e., the cash flows (coupon interest and face value) from the bond do not change. Thus, as market rates increase, demand for and prices of existing bonds decline, because these bonds are now less valuable as an investment. (When market interest rates goes up the opposite is true). Yield to maturity – is the return from a bond during its remaining life (until it matures). This is calculated by finding (solving for) the discount rate which equate the bonds future cash flows (coupon interest and redeemable price (face value)) to its current observed price. YTM is considered RRR of the bond, because if RRR was different, a different price, not the price we have observed, should have been there in the market.
Topic 4 Bonds Valuation – Par, Premium and Discount Bonds o If a bond’s coupon rate is equal to the market rate, bond will sell at a price equal to its face value; these are called par bonds (I = C) o If a bond’s coupon rate is less than market rate, then bond will sell at a price less than its face value; these are called discount bonds (I > C) o If a bond’s coupon rate is greater than market rate, then bond will sell at price more than its face value; these are called premium bonds (I < C) Interest rate risk o If market interest rates are expected to increase in the future, portfolio managers (finance managers) should avoid investing in long term debt securities (e.g., bonds) now. (Longer term bonds experience a larger decline than shorter-‐term bonds.) • Portfolio could see significant decline in value o If you are an investor and you expect interest rates to decline, you will want to invest in long-‐term bonds now. • As interest rates decline, price of long-‐term bonds will increase more than price of a short-‐term bond. Explanation of negatively related relationship bonds prices and Interest rates o Bond prices and market interest rates are negatively related because, despite the change in the market rate, the coupon rate is constant over the life of the bond. I.e., the cash flows (coupon interest and face value) from the bond do not change. Thus, as market rates increase, demand for and prices of existing bonds decline, because these bonds are now less valuable as an investment. (When market interest rates goes up the opposite is true). Yield to maturity – is the return from a bond during its remaining life (until it matures). This is calculated by finding (solving for) the discount rate which equate the bonds future cash flows (coupon interest and redeemable price (face value)) to its current observed price. YTM is considered RRR of the bond, because if RRR was different, a different price, not the price we have observed, should have been there in the market.
