ECON 3420 Discussion 1

ECON 3420 Discussion 1 - 1. Risk: Mean return: A<B<C...

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Unformatted text preview: 1. Risk: Mean return: A<B<C A<B<C Asset A has the lowest risk. It is because the bond is issued by the Chinese government. The probability that the Chinese government goes bankrupt is very low. Even if the government does not have sufficient money to repay the bond, it can still issue new bonds in the market to collect money from the public in order to repay the bonds. Moreover, the rate of return is stated in the contract between the government and investors. Therefore, the rate of return does not fluctuate and its variance is equal to zero. Asset B has a higher risk than asset A. It is because asset B is a stock of a private enterprise. The price of the stock is greatly affected by the performance of Sino Group. For instance, if Sino Group performs well, investors will expect that its stock price will rise and then they will increase their stock holding of this company. This would increase the return of stock. But unlike asset A, there is no contract stated for the rate of return of the stock. So, rate of return may fluctuate and it depends on the market demand and supply of the stock. Hence, its variance is larger than that of asset A. Asset C has the highest risk among these three assets. It is because if there is 1% increase of Hang Seng Index, its value will increase by 10% and vice versa. Therefore, a small change in Hang Seng Index will cause a great change in the value of asset C. Since Hang Seng Index consists of many stocks, therefore, a decrease or increase in one single stock can make Hang Seng Index fluctuate. Therefore, rate of return of asset C varies greatly because of fluctuation of Hang Seng Index. Hence, its variance is the largest among these three assets. Mean return of an asset regards as the compensation for the investors to bear the risk of their investment. It equals to the expected return of the investors. Since we assume that the investors are risk-averse, they need a higher compensation for a riskier investment. It also implies that there is no “free lunch” in the world, higher return comes at the expense of higher risk. So, asset A has the lowest risk and return while asset C has the highest risk and return and asset B has the risk and return between that...
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This note was uploaded on 03/03/2012 for the course ECON 3420 taught by Professor Kwong during the Spring '11 term at CUHK.

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ECON 3420 Discussion 1 - 1. Risk: Mean return: A<B<C...

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