CH 11 - 1 The risk profile of different investment classes

Question 1

1. General Concepts

Answer 1

Risk-Return Tradeoff: Higher-risk asset classes generally offer greater potential returns over the long term, though short-term price fluctuations can depress values.
Financial Product Providers: Major investors in all markets, matching asset proceeds to benefit outgo.

Question 2

1.1 Government Bond Markets

Answer 2

Purpose: Governments issue bonds to finance fiscal deficits.

Key Features:
* Secure and low-risk in developed countries.
* Suitable for matching guaranteed payments (e.g., annuities).
* Large issues enhance marketability.

Risks: Fixed-interest bonds expose investors to inflation risk.

Example: UK government bonds have maturities up to 50 years, influenced by demand from annuity providers.

Question 3

1.2 Corporate Bond Markets

Answer 3

Risks:
* Default Risk: Possibility of issuer defaulting.
* Inflation Risk: Decline in real returns.
* Marketability & Liquidity Risks: Less marketable and liquid than government bonds.

Spread: Difference between yields on corporate and equivalent government bonds reflects these risks.

Expected vs. Actual Return: Expected return is higher than government bonds, but actual returns depend on risk outcomes.

Buy-and-Hold Investors:
* Retain marketability and liquidity premiums.
* No need to sell bonds before maturity increases their value.

Question 4

1.3 Equity Markets

Answer 4

Risks:
* Default, marketability, liquidity risks.
* Uncertain dividend stream and resale price.
* Contagion risk due to market sentiment (e.g., global equity market falls triggered by events in the USA).

Long-Term Benefit: Real investment, protects against inflation risk over time.

Market Volatility:
Short-term contagion effects often revert to previous levels after turmoil.
Reversion may take days or weeks.

Question 5

1.4 Guarantees and Investment Choices

Answer 5

Guarantees: Financial products often offer guarantees.
* Capital Requirements: Regulators require capital against guarantees to protect customers.
* Matching guarantees with asset returns reduces required capital.

Risk Appetite:
* Driven by free capital available.
* Greater free assets allow providers to depart from well-matched positions in pursuit of higher returns.