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Return on Financial Assets
Finance & Accounting
Pages 4 (1004 words)
Consider the following four debt securities, which are identical in every characteristic except as noted: W: A corporate bond rated AAA X: A corporate bond rated BBB Y: A corporate bond rated AAA with a shorter time to maturity than bonds W and X Z: A corporate bond rated AAA with the same time to maturity as bond Y that trades in a more liquid market than bonds W, X, or Y 1.
This risk-return trade-off indicates that the security with the highest risk will provide the most return on a security. Securities with high level of uncertainty will automatically yield a higher rate of return. Another way of looking at this is that, the return will be high if there is a possibility of losing. A corporate bond has various risks attached to it and some of the prominent ones include maturity risk, default risk, liquidity and credit rating risk. Each bond is discussed below with regard to the risk attached to it. I. Bond X among other bonds is the riskiest; therefore, it will earn the highest return for an investor. Its credit rating is the weakest amongst all, which means that there is high proportion of maturity, default and liquidity risk in it. II. Bond W will earn a return lower than X, but higher than the others. It has a slightly better credit rating which means that the level of uncertainty is low. ...
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