Lecture6 - LECTURE 6 Risk and Return, Part 1 &...

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L ECTURE 6 Risk and Return, Part 1 & Valuation of Bonds with Credit Risk Reading: Chapter 6, section 6.5 Homework: the online problems plus the problems at the end of these notes. Objectives: Understand why investors demand compensation for undertaking risk Understand the implications of investor risk aversion for discount rates and bond pricing Be able to decompose the yield on a zero coupon bond with credit risk into its components Understand the difference between a bond’s credit spread and risk premium
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R ISK A VERSION Consider the following gamble: I flip a coin. If it’s heads, you get $100. If it’s tails, you get nothing. How much are you willing to to pay to buy a 50% chance at winning $100?
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RISK AVERSION, CONT. If you say $50, you are risk neutral $50 is the expected value of this gamble: 50 = 0.5*100 + 0.5*0 Or expressed in symbols: E[Gamble] = p*H + (1-p)* L Where H is the high payoff, in this case $100, and p is the probability that you will get H. L is the low payoff, which in this case is zero.
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Are you Risk Averse? If you’re like most people, you said something less than 50. That makes you risk averse. This means that the chance of winning $50 isn’t worth enough to you to offset an equal chance of losing $50 Another way of putting it, risk aversion is a consequence of the diminishing marginal utility of wealth (you’ll learn more about this if you take more finance classes).
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A RISKY ZERO COUPON BOND Now let’s turn our gamble into a security. Suppose I decide to start a corporation called Subprime, Inc., which specializes in buying very risky subprime mortgages from banks. Suppose Subprime, Inc. issues a zero coupon bond that promises to pay $1000 in five years time.
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture6 - LECTURE 6 Risk and Return, Part 1 &...

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