Finance
| FNCE 10001 | Assignment 1 | | Thomas Hu 586870 | 8/12/2012 |
Tutorial: Thursday 1:00pm-2:00pm |
Question 1
A risk premium is the difference in value between the expected return on a security and the interest rate on an alternative, “risk-free” investment both of the same maturity. An asset’s risk premium is a form of compensation for investors who are willing to take on the uncertainties associated with a risky investment. This is used to attract investors to purchase equity securities from a corporation by giving them the potential for a larger return than a riskless alternative such as depositing money in a bank. For instance, risk premium can be expressed as an interest rate that is paid on investments; the high-quality bonds of a well-established corporation, such as a bank, have very little risk of default and hence will pay a relatively low interest rate. Less established companies carry a greater uncertainty in profits and thus might be forced to include a higher interest on investments to attract investors. Therefore, the reason why investors demand a risk premium is to increase the expected value of an investment and compensate them for taking on the risks involved with investing in a company by introducing higher rates of interest for bonds with higher risk of default.
Risky investment
Risky investment
Risk premium
Risk premium
Level of Risk
Expected Return
Level of Risk
Expected Return
Risk-free
Return
Risk-free
Return
Question 2
Part A
The bank will provide debt financing in the form of a loan. This means that the bank will likely lend her money with the promise that she will pay the money back to the lender, with an additional sum of money, in fixed payments at fixed intervals until maturity. The amount that she must pay will be the original sum of the loan (the principal) as well as an interest on her loan. Other characteristics of debt are that the bank has no interest in the future profits of the business
Tutorial: Thursday 1:00pm-2:00pm |
Question 1
A risk premium is the difference in value between the expected return on a security and the interest rate on an alternative, “risk-free” investment both of the same maturity. An asset’s risk premium is a form of compensation for investors who are willing to take on the uncertainties associated with a risky investment. This is used to attract investors to purchase equity securities from a corporation by giving them the potential for a larger return than a riskless alternative such as depositing money in a bank. For instance, risk premium can be expressed as an interest rate that is paid on investments; the high-quality bonds of a well-established corporation, such as a bank, have very little risk of default and hence will pay a relatively low interest rate. Less established companies carry a greater uncertainty in profits and thus might be forced to include a higher interest on investments to attract investors. Therefore, the reason why investors demand a risk premium is to increase the expected value of an investment and compensate them for taking on the risks involved with investing in a company by introducing higher rates of interest for bonds with higher risk of default.
Risky investment
Risky investment
Risk premium
Risk premium
Level of Risk
Expected Return
Level of Risk
Expected Return
Risk-free
Return
Risk-free
Return
Question 2
Part A
The bank will provide debt financing in the form of a loan. This means that the bank will likely lend her money with the promise that she will pay the money back to the lender, with an additional sum of money, in fixed payments at fixed intervals until maturity. The amount that she must pay will be the original sum of the loan (the principal) as well as an interest on her loan. Other characteristics of debt are that the bank has no interest in the future profits of the business