Merrill Finch Inc.
8 – 23 MERRILL FINCH INC. RISK AND RETURN
a. (1) Why is T-bill’s return independent of the state of the economy? Do T-bill’s promise a completely risk-free return? Explain
(2) Why are High Tech’s returns expected to move with the economy, whereas, Collections’ are expected to move counter to the economy?
1. The 5.5% T-bill return does not depend on the state of the economy because the Treasury must redeem the bills at par regardless of the state of the economy; therefore, T-bills are risk-free in the default risk sense because the 5.5% return will be realized in all possible economic states. Consequently, this return is composed of the real risk-free rate, (i.e. 3%, plus an inflation premium, say 2.5%). As the economy is full of uncertainty about inflation, it is unlikely that the realized real rate of return would equal the expected 3%. For example, if inflation averaged 3.5% over the year, then the realized real return would only be 5.5% – 3.5% = 2%, not the expected 3%. To simplify matters, in terms of purchasing power, T-bills are not riskless. Investors are fully aware of the changes within a portfolio of T-bills, and as rates declined, the nominal income will fall; and T-bills are exposed to reinvestment rate risk. In summary, it is concluded that there are no truly risk-free securities within the United States. If the Treasury sold inflation-indexed, tax-exempt bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.
2. High Tech’s returns move with, hence are positively correlated with, the economy, because the firm’s sales, and hence profits, will generally experience the same type of difficulties as the economy. If the economy is booming, so will High Tech. On the other hand, Collections is considered by many investors to be a hedge against bad times and high inflation, so if the stock market crashes, investors in this stock should do relatively well. Stocks such as Collections are
a. (1) Why is T-bill’s return independent of the state of the economy? Do T-bill’s promise a completely risk-free return? Explain
(2) Why are High Tech’s returns expected to move with the economy, whereas, Collections’ are expected to move counter to the economy?
1. The 5.5% T-bill return does not depend on the state of the economy because the Treasury must redeem the bills at par regardless of the state of the economy; therefore, T-bills are risk-free in the default risk sense because the 5.5% return will be realized in all possible economic states. Consequently, this return is composed of the real risk-free rate, (i.e. 3%, plus an inflation premium, say 2.5%). As the economy is full of uncertainty about inflation, it is unlikely that the realized real rate of return would equal the expected 3%. For example, if inflation averaged 3.5% over the year, then the realized real return would only be 5.5% – 3.5% = 2%, not the expected 3%. To simplify matters, in terms of purchasing power, T-bills are not riskless. Investors are fully aware of the changes within a portfolio of T-bills, and as rates declined, the nominal income will fall; and T-bills are exposed to reinvestment rate risk. In summary, it is concluded that there are no truly risk-free securities within the United States. If the Treasury sold inflation-indexed, tax-exempt bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.
2. High Tech’s returns move with, hence are positively correlated with, the economy, because the firm’s sales, and hence profits, will generally experience the same type of difficulties as the economy. If the economy is booming, so will High Tech. On the other hand, Collections is considered by many investors to be a hedge against bad times and high inflation, so if the stock market crashes, investors in this stock should do relatively well. Stocks such as Collections are